Six sure ways to value a stock
There are six benchmarks that determine a stock’s true value, this U.S. advisory says, featuring three value stocks that make all six grades.
“Price is what you pay. Value is what you get.”
That endlessly-quoted saying from Mr. Warren Buffett is well worth keeping in mind when it comes to picking stocks.
For any worthwhile approach must get down to the essential value of a stock. What is it really worth? And what will it be worth in the future?
Indeed, you might define a value stock as one that has deep pockets and the potential to make them deeper still.
Indeed, you might define a value stock as one that has deep pockets and the potential to make them deeper still.
There are many ways to measure the enduring financial fitness of a stock. But according to a leading U.S. advisory that specializes in these things, six measurements work best.
Dow Theory Forecasts has a system for judging stocks that hinges on several categories, including Value. In its latest issue, the advisory says that Value has been the single indicator of successful stocks.
We’ll examine the six benchmarks it uses to determine Value. Then we’ll get three buys that measure up to those benchmarks.
More earnings for the buck
The first benchmark gets right to the heart of the matter. “This metric measures the relative value of the business, not just the stock,” says the advisory.
It is the Enterprise Value/EBITDA ratio. Enterprise value basically means what it would cost to buy the company. It is determined by stock market value plus outstanding debt plus preferred stock minus cash.
On the bottom half of the ratio comes EBITDA — 12-month trailing earnings before interest, taxes, depreciation and amortization. This strips out non-cash and financing charges, giving a cleaner picture of earnings.
A lower ratio generally means you’re getting more earnings for the buck. It can signal an undervalued stock — or even a takeover candidate. (But it’s hard to give a standard “low” or “high” score, since the ratio varies from industry to industry. The average is about 5 in the auto industry, for instance, and closer to 40 for the software business.)
Next comes the price-to-cash flow ratio. Cash flow is defined as net income plus depreciation and other non-cash charges. As a rule, if the ratio is five times or less, the stock is in good shape. If the price of the stock outpaces cash flow by too much, it’s probably living beyond its means.
Number three is a variation on number two — price-to-free-cash flow. Free cash flow is operating cash minus dividends and capital spending. It tells us how much cash companies have to pay out in dividends, buy back shares and acquire other companies.
A popular ratio
The price-earnings (P/E) ratio needs little introduction. The closer to 20 it gets, the more likely it is that the stock has maxed out its value.
“Critics note that this popular ratio can be distorted by accounting conventions that skew reported profits,” says the advisory, “but it has provide to be reliable for identifying stocks that outperform.”
Number five is price-to-sales ratio. Comparisons of share price to sales ratio can unduly reward firms with low margins, the advisory admits, but this ratio has a good track record. A low ratio of no more than one or two times is good.
The final benchmark is simply the price-to-sales-ratio against a five-year median. In short, it carries the figure back in time to account for good and not-so-good years (of which there have been a few lately).
Measured by these six benchmarks, the top 20 per cent of the stocks traded in the U.S. outpaced the average stock by 3.8 per cent over the past 18 years. That’s a considerable margin over almost two decades.
The cheapest drug company
Putting these figures to work, the advisory comes up with “three intriguing options” among the stocks it monitors. All are buys.
The first is big British drugmaker AstraZeneca (NYSE-AZN). It scores very high on three of the six benchmarks, most notably the Enterprise Value/EBITDA ratio.
The stock is trading at less than eight times trailing earnings, a 38 per cent discount based on its five-year average. Based on its P/E ratio, it is the cheapest among drug companies with market caps over $50 billion.
The stock took off in early 2010 after strong December-quarter results, and has since slid back with the stumbling market. Wall Street projects growth of 26 per cent this year, and AstraZeneca has beaten the consensus by 6 per cent each of the last four quarters.
The advisory calls it one of the steadiest stocks it follows. It is trading at $44.19 and yielding a lofty 7.9 per cent on a hefty dividend of $3.42.
Comcast (NASDAQ-CMCSA) boosted its per-share profits by at least 10 per cent in nine consecutive quarters. Both its free cash flow and operating cash flow have jumped considerably.
It uses that cash to raise the dividend, as it did in December and buy back its shares. It plans to buy back about seven per cent over the next three years.
Trading at about five times operating cash flow, Comcast is cheap compared to other big cable and broadcasting stocks. It trades at $15.55 and yields 2.5 per cent on its $0.38 dividend.
The stock of Travelers (NYSE-TRV) went up when the insurance company reported operating income of $2.12 a share for the December quarter, a 34 per cent increase. Revenue was up 11 per cent.
The company has high retention rates, and changes on renewal rates favoured all three of the company’s segments. Of the 130 stocks it monitored that recorded a profit last year, adds the advisory, only three had a lower P/E ratio than Travelers. It trades at just nine times earnings.
The company’s $1.32 dividend yields 2.6 per cent and the stock trades at $49.46.
Over the past few years, some mighty big companies have turned out to have shockingly shallow pockets. Just goes to show, you can never be too careful about getting full value for your investment dollar.
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