The best way to spot cheap shares

Making money in the stock market is easy, in theory at least. Just buy cheap shares, and be patient. Plenty of studies show that value investing buying shares for less than shares are worth' produces superior returns to most other stock-picking methods.

It might not make you rich overnight, but do it for long enough and you should beat the market healthily.

But how do you find cheap shares?

That's where it gets tricky. Most investors start with the price/earnings ratio (p/e). It's simple to calculate (just the company's share price divided by earnings per share) and easy to understand. The lower the p/e, the cheaper the stock (because you're paying less per pound of earnings).

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Buying low p/e stocks can have great results. John Neff, manager of Vanguard's Windsor Fund in the US, used this method to make 13.7% a year on averagebetween 1964 and 1995, compared tojust 10.6% a year for the US stock market. But p/e ratios have lots of shortcomings.

They are based solely on a company's income statement they reveal nothing about balance sheets. And comparing companies is made trickier by accounting quirks, such as different tax rates.

A better way to value stocks

Fortunately, there is a better way to value stocks. Wesley Gray, an American value investing expert, has done lots of research into picking winning shares. For his money, the best valuation measure to use is to compare earnings before interest and tax (EBIT) or trading profits with a stock's enterprise value (EV).

EV includes the market capitalisation(the number of shares multiplied by the share price the market value of a company's equity, in other words).

EV also includes any debt used to fundthe company (such as bank loans or corporate bonds). This gives a more complete picture of the business. By dividing EBIT by EV, you get an earnings yield for the company, expressed as an interest rate. The higher the interest rate, the cheaper the share.

Gray says the EBIT/EV ratio consistently picks better stocks than the p/e. He looked at 1,000 large and medium-sized companies between 1963 and 2013 and ranked them into deciles, based on EBIT/EV. He then put together lots of random 30-stock portfolios.

He found that an investor buying the cheapest shares would have beaten one paying for the more expensive ones handsomely. Not only that, but the cheap shares were also much less risky, with lower levels of volatility.

EBIT/EV works so well because it gives you a lot of information about what you are paying for the assets of a business (which are financed by its equity and its borrowings the EV) and also the profits that they are producing EBIT.

The danger of just focusing on the equity (as the p/e ratio does) is that debt can make assets look cheaper than they really are. You can see how this works in the example in the box below.

The real magic number

Gray is not the first to advocate using EBIT/EV, of course. Joel Greenblatt, author of The Little Book That Beatsthe Market, uses it as a key part of his magic formula' for picking shares.

He ranks shares by their interest ratesand also their return on capital.He reckons this allows him to buygood-quality businesses (as signalled by a high return on capital) at a cheap price (with a high interest rate).

However, Gray thinks you don't even need to bother worrying about return on capital. In fact, he thinks that paying too much attention to this number can tempt you to overpay for quality.

According to Gray, all the magic in Greenblatt's formula comes from the EBIT/EV part so that's what you should focus on. Below I've picked five shares that look good value right now on this EBIT/EV basis.

Why debt matters

Say there are two identical office blocks for sale where you live.Both have an asking price of £1m.Both generate annual trading profits (EBIT) of £100,000.

The first office, known as Market Place, is financed with an £800,000 bank loan (mortgage) at an interest rate of 5%, leaving it with equity of £200,000. Park Square has no debt at all, so has an equity value of £1m.

By using p/e ratios, you could be misled into thinking that Market Place is considerably cheaper than Park Square. But in fact, on the basis of EBIT/EV, they have the same value.

Five cheap sharesto buy now