Numbers can lie -- but 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 cheap iron and metallurgical coal producer Cliffs Natural Resources
The 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. This 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). Like 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.
Cliffs Natural Resources has a P/E ratio of 17.9 and an EV/FCF ratio of 19.7 over the trailing 12 months. If we stretch and compare current valuations to the five-year averages for earnings and free cash flow, Cliffs Natural Resources has a P/E ratio of 26.3 and a five-year EV/FCF ratio of 31.7.
A one-year ratio under 10 for both metrics is ideal. For a five-year metric, under 20 is ideal.
Cliffs Natural Resources is 0 for 4 on hitting the ideal targets, but let's see how it compares against some competitors and industry mates.
|Cliffs Natural Resources||17.9||19.7||26.3||31.7|
Alpha Natural Resources
Source: Capital IQ, a division of Standard & Poor's; NM = not meaningful.
Numerically, we've seen how Cliffs Natural Resources' valuation rates on both an absolute and a 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, Cliffs Natural Resources' net income margin has ranged from 9% to 15.4%. In that same time, unlevered free cash flow margin has ranged from 7.6% to 15.3%.
How do those figures compare with those of the company's peers? See for yourself:
Source: Capital IQ, a division of Standard & Poor's; margin ranges are combined.
Also, over the past five years, Cliffs Natural Resources has tallied up five years of positive earnings and five 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 while 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 has done over the past five years. In that time, Cliffs Natural Resources has put up EPS growth rates of 1.1%. Meanwhile, Wall Street's analysts expect future growth rates of 17%.
Here's how Cliffs Natural Resources compares with its peers for trailing five-year growth:
Source: Capital IQ, a division of Standard & Poor's; EPS growth shown.
And here's how it measures up with regard to the growth analysts expect over the next five years:
Source: Capital IQ, a division of Standard & Poor's; estimates for EPS growth.
The bottom line
The pile of numbers we've plowed through has shown us how cheap shares of Cliffs Natural Resources are trading, how consistent its performance has been, 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 17.9 P/E ratio. Still, the numbers are just a start. For example, your expectations for the future price of iron and metallurgical coal is a big factor in evaluating Cliffs Natural Resources.
If you find Cliffs Natural Resources' numbers compelling, don't stop. Continue your due diligence until you're confident that the initial numbers aren't lying to you.
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Anand Chokkavelu doesn't own shares in any company mentioned. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Fool has a disclosure policy.