Is Devon's Stock As Cheap As Its 5.4 P/E Ratio?

Numbers can lie -- yet they're the best first step in determining whether a stock is a buy. In this series, we use some carefully chosen metrics to size up a stock's true value based on the following clues:

  • The current price multiples.
  • The consistency of past earnings and cash flow.
  • How much growth we can expect.

Let's see what those numbers can tell us about how expensive or cheap Devon Energy (NYSE: DVN  ) might be.

The current price multiples
First, we'll look at most investors' favorite metric: the P/E ratio. It divides the company's share price by its earnings per share (EPS) -- the lower, the better.

Then we'll take things up a notch with a more advanced metric: enterprise value to unlevered free cash flow, which divides the company's enterprise value (basically, its market cap plus its debt, minus its cash) by its unlevered free cash flow (its free cash flow, adding back the interest payments on its debt). As with the P/E, the lower this number is, the better.

Analysts argue about which is more important -- earnings or cash flow. Who cares? A good buy ideally has low multiples on both.

Devon has a P/E ratio of 5.4 and a negative EV/FCF ratio over the trailing 12 months. If we stretch and compare current valuations with the five-year averages for earnings and free cash flow, we see that Devon has a P/E ratio of 15.5 and a negative five-year EV/FCF ratio.

A positive one-year ratio of less than 10 for both metrics is ideal (at least in my opinion). For a five-year metric, less than 20 is ideal.

Devon has a mixed performance in hitting the ideal targets, but let's see how it stacks up against some of its competitors and industry mates. 

Company

1-Year P/E

1-Year EV/FCF

5-Year P/E

5-Year EV/FCF

Devon 5.4 NM 15.5 NM
Apache 9.1 18.4 18.1 32.8
Anadarko Petroleum NM 62.1 27.2 99.8
Noble Energy 21.4 NM 22.5 67.8

Source: S&P Capital IQ; NM = not meaningful because of losses.

Numerically, we've seen how Devon's valuation rates on both an absolute and relative basis. Next, let's examine ...

The consistency of past earnings and cash flow
An ideal company will be consistently strong in its earnings and cash-flow generation.

In the past five years, Devon's net income margin has ranged from -153.7% to 50.7%. In that same time frame, unlevered free cash flow margin has ranged from -26.8% to 13%.

How do those figures compare with those of the company's peers? See for yourself:

Source: S&P Capital IQ; margin ranges are combined.

Source: S&P Capital IQ; margin ranges are combined.

In addition, over the past five years, Devon has tallied up four years of positive earnings and three years of positive free cash flow.

Next, let's figure out ...

How much growth we can expect
Analysts tend to comically overstate their five-year growth estimates. If you accept them at face value, you will overpay for stocks. But even though you should definitely take the analysts' prognostications with a grain of salt, they can still provide a useful starting point when compared with similar numbers from a company's closest rivals.

Let's start by seeing what this company's done over the past five years. In that time period, Devon has put up past EPS growth rates of -6.3%. Meanwhile, Wall Street's analysts expect future growth rates of 8.1%.

Here's how Devon compares with its peers for trailing-five-year growth (because of losses, Anadarko's growth rate isn't meaningful):

Source: S&P Capital IQ; EPS growth shown.

Source: S&P Capital IQ; EPS growth shown.

And here's how it measures up with regard to the growth analysts expect over the next five years:

Source: S&P Capital IQ; estimates for EPS growth.

Source: S&P Capital IQ; estimates for EPS growth.

The bottom line
The pile of numbers we've plowed through has shown us the price multiples that shares of Devon are trading at, the volatility of its operational performance, and what kind of growth profile it has -- both on an absolute and a relative basis.

The more consistent a company's performance has been and the more growth we can expect, the more we should be willing to pay. We've gone well beyond looking at a low 5.4 P/E ratio, and we see that its free cash flows haven't kept up with its earnings because of heavy capital expenditures. These are justified, though, if they result in future profitable growth.

We should also note that the 5.4 P/E ratio is a bit misleading because more than half the earnings come from discontinued operations. And perhaps more important than the recent negative growth is Devon's income-producing assets and future natural gas prices.

Our CAPS community likes what it sees from Devon and rates it five stars out of five, but this is just a start. If you find Devon's numbers or story compelling, don't stop here. Continue your due-diligence process until you're confident one way or the other. As a start, add it to My Watchlist to find all of our Foolish analysis.

If Devon's not your cup of tea or if you just want another stock idea, I wrote about a stock that's flying under the radar in our brand new free report: "The Stocks Only the Smartest Investors Are Buying." I invite you to take a free copy to find out the name of the company I believe Warren Buffett would be interested in if he could still invest in small companies.

Anand Chokkavelu doesn't own shares in any company mentioned. The Motley Fool owns shares of Devon Energy. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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