Warren Buffett often pays homage to his mentor and fellow legendary investor, Ben Graham. One thing Graham said that Buffett takes to heart is: "Price is what you pay; value is what you get." That's an important thing for every investor to remember. Price and value don't always go hand-in-hand.
With this in mind, we asked three Motley Fool investors to identify stocks that look expensive but are actually cheap. Here's why they picked Kinder Morgan (KMI -1.55%), Mattel (MAT -0.51%), and Vertex Pharmaceuticals (VRTX -0.67%).
Ridiculously cheap cash flow
Matt DiLallo (Kinder Morgan): Traditional valuation metrics like the price-to-earnings (P/E) ratio don't work for most energy companies. That's because items like depreciation can artificially deflate earnings, making these stocks look expensive. Cash flow metrics, on the other hand, often tell a much different story.
Take natural gas pipeline giant Kinder Morgan, which currently sells for nearly 33 times earnings. That appears to be a rich valuation considering that the S&P 500 trades at about 26 times earnings. However, one reason Kinder Morgan looks expensive is that it records substantial depreciation, depletion, and amortization (DD&A) expenses, which are non-cash charges.
Last quarter, for example, the company recorded $661 million in DD&A, which helped push net income down to just $334 million, or $0.15 per share. Because of how much these non-cash charges impact earnings, the company uses distributable cash flow (DCF) as its primary earnings metric, since it more accurately reflects the cash generating ability of the business. In the third quarter, DCF was at $1.055 billion, or $0.47 per share, which was more than three times reported earnings.
That result puts Kinder Morgan on pace to produce $4.46 billion or $1.99 per share in DCF for the full year. When we use that number and divide it by Kinder Morgan's recent sub-$19 share price, we see a much different valuation picture since the company trades at less than 10 times DCF. That's ridiculously cheap for a pipeline company considering that most rivals sell for a mid-teens DCF multiple.
A troubled toy maker
Tim Green (Mattel): The situation is looking grim for toy maker Mattel. The stock plunged in October after the company reported dismal third-quarter results, hurt by weak demand for its brands and the bankruptcy of Toys "R" Us. Mattel reported a 13% year-over-year drop in revenue, and it halted its quarterly dividend completely after slashing it earlier this year.
Given all of Mattel's problems, and its net loss of $2.25 per share through the first nine months of the year, the stock certainly doesn't look cheap. But by one measure, Mattel is at its cheapest in nearly a decade. Following the post-earnings plunge, Mattel trades for around 0.95 times its trailing-twelve-month sales. That's the lowest price-to-sales ratio since the depths of the financial crisis.
Let's be clear: Mattel is facing a lot of problems, and the company's efforts to turn itself around under new CEO Margo Georgiadis are still in their infancy. Things may get worse before they get better, and Mattel may never return to the kind of profitability it enjoyed prior to its ongoing crisis. And with no dividend, the reasons to own the stock have dwindled. But Mattel's deeply depressed valuation provides an opportunity for investors willing to bet that the toy maker can eventually stage a comeback.
Expensive biotech stock? Not with its growth potential
Keith Speights (Vertex Pharmaceuticals): Looking at Vertex Pharmaceuticals' earnings multiples might make you want to get out some tissues: They're definitely in the nosebleed category. The biotech stock trades at 51 times expected earnings. Believe it or not, though, Vertex stock is relatively cheap.
First, it's important to understand that any valuation metric based on the biotech's earnings will be suspect. Vertex has reported a profit in only three quarters during this decade. To value Vertex requires taking the approach that hockey great Wayne Gretzky used: Look at where the puck is going, not where it is.
Right now, Vertex has two cystic fibrosis (CF) products on the market: Kalydeco and Orkambi. Orkambi is just picking up momentum. The two drugs combined only address a potential patient population of around 30,000. However, Vertex awaits regulatory approval of a new combination of tezecaftor and Kalydeco that could boost the target patient population up to 44,000.
That's just the beginning. Vertex is evaluating three-drug combos that hold the potential to be even more effective and treat more CF mutations. If clinical studies go well, the company could have treatments for 68,000 CF patients -- around 90% of the market. Vertex is also working on therapies for the remaining CF patients.
Wall Street analysts think these products should allow Vertex to grow earnings by 65% annually over the next five years. With those kind of growth prospects, this biotech stock isn't all that expensive after all.