Not As Pricey As You Think

3/7/2016


Here's a pop quiz.

Based on forward P/E ratio, which one of these sectors is the cheapest?

1) Technology.
2) Consumer staples.
3) Telecommunication services.
4) Health care.

If you selected choice No. 1, pat yourself on the back. Tech stocks have a reputation for being pricey. But in today's market, tech doesn't look especially expensive. Investors can look at valuation from a number of angles, at least three of which paint technology as attractively cheap.

Relative to growth

Some like to value stocks based on the present value of cash flows they'll generate in the future. Logic suggests that a stock capable of growing 10% a year should be worth more than one growing 6% a year, assuming similar levels of risk.

To assess valuation relative to growth potential, we look at the forward price/earnings ratio (current price divided by expected year-ahead profits) and the PEG ratio (forward P/E dividend by the long-term profit-growth estimate). Tech stocks average:

• Forward P/Es of 19.1, fifth-lowest among sectors and in line with the average for all stocks in the index.

• PEG ratios of 1.5, third-cheapest among sectors and also below the index average of 1.7.

Excluding cash

While traditional price/earnings ratios offer a useful take on a stock's value, sometimes we prefer to augment the raw number and consider how much of a stock's price reflects its cash holdings. The average technology stock holds cash equal to 18% of its stock-market value, well above the average of 13% for all stocks in the S&P 1500. While net cash (total cash minus total debt) offers a clearer picture of a company's financial position, the typical firm carries more debt than cash, rendering net cash useless as a tool for adjusting P/E ratios for most stocks.

If we recalculate price/earnings ratios after reducing share prices to account for cash holdings, tech stocks average forward P/E ratios of just 16.1, second-lowest among all sectors, versus the index average of 17.2.

Versus history

Comparing current valuation ratios with historical norms, tech stocks seem somewhat cheap.

The average tech stock trades at 7.0 times trailing 12-month operating cash flow, second-highest among all the sectors. However, those stocks average a 3% discount to their five-year average P/CFO ratio. For context, the typical stock in the S&P 1500 sports a 6% discount, and four of the 10 sectors trade at a premium to historical norms. While tech valuations look rich on an absolute basis, comparing them to their own history brings the stocks back to the middle of the road.

Tech stocks look even cheaper relative to historical norms for price/sales and price/book ratios, ranking among the cheapest four of the 10 sectors. See the table below for details.

CHEAPER THAN USUAL
On average, technology stocks in the S&P 1500 Index trade at a 3% discount to their five-year average price/operating-cash-flow ratio, not far from the broad index's average of 6%. Tech looks cheaper relative to five-year average price/sales and price/book ratios.
Discount (Premium)
--------- To 5-Year Average ---------
Sector
P/CFO
(%)
P/S
(%)
P/B
(%)
Cons. discretionary
(7)
(4)
6
Consumer staples
4
19
24
Energy
(37)
(32)
(40)
Financials
(3)
2
(1)
Health care
16
8
8
Industrials
(12)
0
4
Materials
(21)
(6)
(2)
Technology
(3)
(2)
4
Telecom services
13
13
5
Utilities
16
23
13
S&P 1500
(6)
0
4
Tech sector rank
5
4
4

Moral of the story

Don't shy away from investing in technology because you fear the stocks are too expensive. The sector as a whole seems reasonably valued. More importantly, we can find attractive values among individual technology stocks, such as the ones in the table below. Four of our favorites are profiled in the following paragraphs:

Apple ($101; AAPL) earns a Quadrix Value score of 90 — not because it looks exceptionally cheap based on a few valuation metrics, but because it looks moderately cheap almost across the board. The stock scores in the top half (above 50) in 86% of the statistics we use to compute the Value score.

Apple trades at 11 times estimated year-ahead profits, cheaper than 78% of technology stocks in the S&P 1500. The PEG ratio of 0.78 is also unusually low — just 22% of tech stocks have PEG ratios below 1.0, and only 9% look cheaper than Apple using that metric.

While the consensus projects a slight decline in profits in fiscal 2016 ending September, analysts expect a return to double-digit growth in fiscal 2017. The long-term growth target of 14% annually seems optimistic, but the stock is cheap if Apple can deliver even half that growth rate. Apple, yielding 2.1%, is a Focus List Buy and a Long-Term Buy.


F5 Networks ($100; FFIV) doesn't normally distinguish itself from the pack because of its valuation. When the stock joined our Buy and Long-Term Buy lists in November 2014, we were reacting to its growth, not its value. However, the shares appear especially cheap relative to historical norms.

A trailing price/earnings ratio of 15 and price/sales ratio of 3.5 are both at least 25% below their respective five-year averages. F5 earns a Value score of 74 — solid, if not great, and well above the 10-year average of 42.

F5's profit growth has slowed in recent quarters, but the company has managed at least 6% growth in 10 of the last 13 quarters, while sales rose at least 6% in 11 of the last 13. Over the last 12 months, sales rose 9%, per-share profits 15%, and operating cash flow 22%. Analysts' profit-growth targets appear modest (5% in fiscal 2016 ending September and 10% in fiscal 2017), hurt in part by the company's conservative guidance. However, F5's inroads in the security business and strong orders for new products increase our confidence in future growth. F5 is a Buy and a Long-Term Buy.


With a forward P/E ratio of 12, Lam Research ($75; LRCX) trades at a 47% discount to the average technology stock as well as the average for its industry, semiconductor equipment. Not a bad valuation, but it gets even better when adjusted for cash. Lam holds $4.48 billion in cash, which equates to $25.69 per share, or 34% of the stock price. Wash out that cash, and Lam trades at eight times trailing earnings. Excluding Lam's $2.10 billion in net cash, or total cash minus total debt, the P/E ratio is 10.

Lam's Quadrix Value score of 84 is the highest in its industry, helped by top-quintile (top one-fifth) ranks for price/earnings relative to three- and five-year medians and PEG ratio. The valuation seems even more impressive when you consider the type of growth Lam can deliver. Analysts expect per-share-profit growth of more than 17% this year and next year. Per-share profits rose 33% over the last 12 months and 60% annually over the last three years. Lam is a Buy and a Long-Term Buy.


Over the last 12 months, Skyworks Solutions ($69; SWKS) grew per-share profits 57%. That torrid growth continued a longstanding trend — profits rose at an annualized rate of 59% over the last three years and 42% over the last 10. The consensus calls for profits to rise 9% in fiscal 2016 ending September, dragged down by concerns about slowing growth in China and chinks in the armor of Apple's ($101; AAPL) iPhone, which accounts for an estimated one-third of Skyworks' revenue.

However, Skyworks also supplies smartphones for other platforms, and its best long-term growth engine may be the so-called internet of things. While phones remain Skyworks' most important end market at the moment, the company supplies semiconductors for thousands of other products ranging from medical equipment to automobiles to consumer electronics. In November, researcher Gartner estimated that 5.5 million new things will get connected every day this year. Gartner projects 6.4 billion connected things by the end of 2016 (up 30% from 2015) and 20.8 billion by 2020. Talk about a target-rich environment.

Analysts expect Skyworks to return to double-digit profit growth starting in fiscal 2017. Yet Skyworks earns a Value score of 76 and trades at just 12 times expected year-ahead earnings. Excluding the company's $1.23 billion ($6.33 per share) in cash, the P/E ratio falls below 11. Skyworks is a Buy and a Long-Term Buy.

CHECK OUT THESE TECHNOLOGY VALUES
The A-rated tech stocks below earn Quadrix Value scores of at least 70 and stand out because of their attractive valuations excluding cash, relative to history, or relative to growth potential. Stocks on our buy lists are in bold.
Stock-
Market
Value
($Bil.)
Forward P/E Ratio
Cash As
% Of
Market
Value*
Discount (Premium)
----- To 5-Year Average -----
Estimated
-- Profit Growth --
Quadrix Scores
Company (Price; Ticker)
Including
Cash
Excluding
Cash
Price/
Cash From
Operations
(%)
Price/
Sales
(%)
Price/
Book
(%)
PEG
Ratio

Year
Ahead
(%)

Next
5 Years
(Annual.)
(%)
Value
Overall
Apple ($101; AAPL)
562.4
11
7
36
(28)
(30)
(13)
0.77
(2)
14
90
87
Cisco Systems
($27; CSCO)
135.0
12
7
45
(2)
9
3
1.62
1
7
75
91
F5 Networks
($99; FFIV)
6.8
14
12
12
NM
(40)
(16)
1.18
3
12
74
85
Intel ($30; INTC)
143.5
13
11
18
5
1
(9)
1.48
0
9
76
78
Jabil Circuit
($21; JBL)
4.1
8
6
28
(39)
(13)
(15)
0.68
11
12
94
92
Lam Research
($76; LRCX)
12.0
12
8
35
(1)
(9)
1
0.89
1
13
84
98
Skyworks Solutions
($70; SWKS)
13.5
12
11
10
7
(8)
(1)
0.58
4
21
76
87
Note: Quadrix scores are percentile ranks, with 100 the best.     * Includes investments.    

 


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