Three Key Valuation Ratios

4/25/2011


The last couple of years have been mostly kind to stock investors. But the broad-based rally has left those investors with a difficult job — finding high-potential stocks that are truly cheap. Thankfully, Quadrix® excels at uncovering standout value plays.

Among the dozens of variables considered by our stock-rating system, three used in the Value score have proved especially effective predictors of stock performance. These three factors typically rank among the top 15 in our back-tests:

Price/cash flow ratio. Earnings, which take into account a variety of noncash items, can sometimes paint a skewed picture of a company’s operating strength. For this ratio we use the shorthand version of cash flow, which equals net income plus such noncash expenses as depreciation and amortization.

The metric works well in all the periods we tested, particularly the past decade. In 12-month holding periods over the last 10 years, the cheapest one-fifth of Dow Jones U.S. Index stocks as measured by price/cash flow outperformed the average stock in the index by an average of 7.2%. During that span, the top scorers outperformed in 76% of periods, an excellent winning percentage.

Price/sales ratio. Revenue is relatively difficult to manipulate and less influenced by accounting decisions that can affect earnings and book value. The price/sales ratio is a fairly stable and reliable measure of valuation.

The price/sales ratio has been the most effective individual Quadrix factor over the last five and 10 years — ranking No. 2 since 1995. Over the last 10 years, top scorers in price/sales have averaged outstanding 12-month outperformance of 10.0%.

Enterprise ratio, or EV/EBITDA. This ratio approximates a company’s total takeover price relative to its underlying earning power. This statistic allows comparisons of companies with varying levels of debt. EV stands for enterprise value, the combined value of a company’s debt and stock-market value minus its cash. EBITDA equals earnings before interest, taxes, depreciation, and amortization.

The enterprise ratio boasts the highest winning percentage of all Quadrix factors for the last five, 10, and 15 years. In 12-month periods since 1995, the top one-fifth of Dow Jones U.S. Index stocks as measured by the ratio outperformed the average stock by a healthy 5.1%.

CONSISTENT QUADRIX PREDICTORS
Among the more than 100 variables monitored in our Quadrix® stock-rating system, price/cash flow, price/sales, and enterprise ratio (enterprise value divided by EBITDA) have been excellent predictors of stock performance. In rolling 12-month periods over the last five, 10, and 15 years, all three ranked among the 15 most effective factors for both outperformance (average performance of cheapest top one-fifth of the Dow Jones U.S. Index minus the average stock in the index) and winning percentage (number of positive periods divided by total periods).
----------- Outperformance of Cheapest One-Fifth of Stocks -----------
-------- 5 Years --------
-------- 10 Years --------
-------- 15 Years --------
Return
(%)
Rank
Return
(%)
Rank
Return
(%)
Rank
Price/Cash Flow
5.2
7
7.2
3
4.0
8
Price/Sales
7.1
1
10.0
1
5.7
2
Enterprise Ratio
4.8
10
7.6
2
5.1
3
----------------------------- Winning Percentage -----------------------------
-------- 5 Years --------
-------- 10 Years --------
-------- 15 Years --------
%
Rank
%
Rank
%
Rank
Price/Cash Flow
68
4
76
2
68
4
Price/Sales
58
14
75
3
68
4
Enterprise Ratio
75
1
85
1
74
1

Listed in the table below and reviewed in the following paragraphs are high-potential value plays. To make the cut, a stock needed Overall and Value scores above its industry average. In addition, we screened for names that rank near the cheapest 20% of U.S.-traded stocks on at least two of the three highly effective valuation metrics.

Exelon’s ($40; EXC) shares have come under pressure, in part from concerns about its 2012 outlook, with per-share profits expected to plunge 25% due to unfavorable pricing conditions and the expiration of hedges on power prices that have kept annual profits above $4.00 per share. Japan’s nuclear scare hasn’t helped matters, considering that nuclear plants generate more than 80% of Exelon’s electricity supply.

Utilities average a Quadrix Value score of 70, the highest of any sector. But even relative to its peers, Exelon’s valuation looks attractive. At less than 10 times trailing earnings, the shares trade 28% below the S&P 1500 Index peer-group average and 34% below its own five-year average P/E. The shares also trade at discounts of at least 30% for price/book, price/sales, and enterprise ratio. Exelon’s 5% yield is backstopped by a solid balance sheet. Exelon, rated A (above average), is a component of our Top 15 Utilities portfolio.


Hess ($79; HES) seems cheap versus the energy sector. Its shares trade at less than one times trailing sales, a 71% discount to the sector average, and about five times trailing cash flow, a 47% discount. Hess’s enterprise ratio is 45% below the sector average.

In the past five years, Hess has increased its proved reserves by a total of 41%. It currently owns 10 years of proved reserves and plans to grow both reserves and production at an annual rate of 3% in coming years. Crude oil and natural gas liquids combine for a larger portion of proved reserves than they did five years ago. That focus on oil looks good, given Hess’s unhedged exposure to oil prices that hover near $110 per barrel. Hess also owns a 50% stake in an oil refinery, a chain of 1,362 gas stations, and 20 storage terminals scattered along the Atlantic coast.

Rising analyst estimates target March-quarter profits of $1.86 per share, up 25%, on 3% revenue growth. Slated to announce March-quarter results April 27, Hess is a Buy and a Long-Term Buy.


Hewlett-Packard ($40; HPQ), a favorite punching bag for investors and rival executives, has seen its image battered and shares bruised. H-P may not be run by a confederacy of dunces, but it serves up plenty of material to feed its critics: the questionable handling of former CEO Mark Hurd’s dismissal, a string of pricey acquisitions, and, most recently, disappointing guidance for the April quarter.

After slumping 25% over the last 12 months, H-P shares look cheap. H-P’s enterprise ratio has dipped below six, 39% below the average for computer-hardware stocks in the S&P 1500 and 31% below the stock’s five-year average. The stock’s trailing P/E ratio of eight is the lowest in more than a year.

H-P’s exposure to the personal-computer market is cause for some concern. But despite all its troubles, H-P is still expected to grow per-share profits 14% to $5.24 in fiscal 2011 ending October. Should H-P hit that target and its P/E merely rise to its fiscal 2010 month-end low of 9.5, shares would surge to $50. Earning a Value score of 97, Hewlett-Packard is a Buy and Long-Term Buy.


Research In Motion ($53; RIMM) has launched its PlayBook tablet, a device critical to the company’s long-term success. The tablet’s new operating system garnered rave reviews, though critics panned its software, which some said made the device seem incomplete, as if it had been rushed to market. Although software weakness could limit functionality in the short-term, software updates should continue to enhance the product and help it carve out a niche in the corporate world.

There’s a sharp divide over RIM’s outlook. Some analysts proclaim the PlayBook tablet as the leading challenger to Apple’s iPad, while others have dubbed it dead on arrival. That dissension is reflected in analyst profit estimates for fiscal 2012 ending February, which range from a 20% decline to a 19% advance. Of course, trading at just eight times the 2012 consensus profit estimate, RIM doesn’t need to manage much growth to justify a higher share price.

With an enterprise ratio of less than five — 40% below rivals in the S&P 1500 Index and 73% below its five-year average — the stock seems unduly cheap. Research In Motion is a Buy and a Long-Term Buy.

SCREEN OF THE MONTH: VALUE LEADERS
All 11 of the A-rated stocks listed below earn Quadrix Overall and Value scores above their industry averages. Importantly, all 11 rank near the top 20% of U.S.-traded stocks on at least two of the three most consistently predictive metrics in Quadrix — price/cash flow, price/sales, and enterprise ratio. An A rating translates to above average. Stocks recommended for purchase in the Forecasts are listed in bold.
Price/Cash
----- Flow -----
Price/
----- Sales -----
Enterprise
---- Ratio ----
Quadrix
----- Scores -----
Quadrix
Industry
--- Averages ---
Company (Price; Ticker)
Ratio
Rank
Ratio
Rank
Ratio
Rank
Value
Overall
Value
Overall
Chevron ($105; CVX)
6.5
84
1.1
64
5.2
86
81
98
69
81
Integrated Oil & Gas
ConocoPhillips
($78; COP)
5.4
89
0.6
80
5.7
83
77
92
69
81
Integrated Oil & Gas
Dell ($15; DELL)
8.2
74
0.5
87
4.5
91
95
91
57
59
Computer Hardware
Exelon ($40; EXC)
5.7
88
1.4
54
5.5
84
90
75
74
59
Electric Utilities
Hess ($79; HES)
5.4
89
0.8
74
5.3
86
87
96
69
81
Integrated Oil & Gas
Hewlett-Packard
($40; HPQ)
6.4
85
0.7
78
5.7
83
97
73
57
59
Computer Hardware
Intel ($20; INTC)
6.8
83
2.5
33
4.6
90
96
94
56
65
Semiconductors
L-3 Communications
($76; LLL)
7.1
81
0.5
85
6.2
79
97
77
55
56
Aerospace/Defense
Research In Motion
($53; RIMM)
6.6
84
1.4
54
4.8
89
98
98
44
49
Telecom Equipment
Travelers ($58; TRV)
6.5
84
1.0
66
4.1
92
89
79
67
51
Ppty. & Cas. Ins.
UnitedHealth Group
($44; UNH)
8.4
72
0.5
86
5.4
85
85
88
78
81
Mgd. Health Care
Note: Quadrix scores are percentile ranks, with 100 the best.

 


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