There are many ways to value a company. Price to earnings. Price to cash flow. Liquidation value. Price per eyeballs on website. Price to a number I completely made up (this one never gets old). Price to CEO's ego divided by lobbying activity as a percentage of revenue (this one doesn't get used enough).
Which one is best? They're all limited and reliant on assumptions. No single metric holds everything you need to know.
The metric I'm using today is no different. But it's perhaps the most encompassing and least susceptible to hidden complexities of a company's financial statements. The more I think about it, the more I feel it's one of the most useful metrics out there.
What is it? Enterprise value over unlevered free cash flow.
Enterprise value is market capitalization (share price times shares outstanding) plus total debt and minority interests, minus cash. Unlevered cash flow is free cash flow with interest paid on outstanding debt added back in.
The ratio of these two statistics provides a valuation metric that takes into consideration all providers of capital -- both stockholders and bondholders.
But you invest in common stock, so why should you care about bondholders? Ask Lehman Brothers investors why. When a company earns money, it has to take care of bondholders before you, the common shareholder, gets a dime. Focusing solely on profits in relation to equity can be dangerously misleading. And often is.
Enterprise value provides a more encompassing view. By bringing debt capital into the situation, we see real earnings in relation to the company's entire capital structure. If you owned the entire business, this is the metric you'd naturally gravitate toward.
Using this metric, here are five companies I found that look attractive.
Enterprise Value/ Unlevered FCF
Source: Capital IQ, a division of Standard & Poor's
Let's say a few words about these companies.
Earlier this summer, I said Microsoft might be one of the cheapest stocks out there. I still feel that way. Take a world-class company with a huge moat and more cash than it knows what to do with, add in a stock that trades at about 10 times forward earnings, and good things will happen.
The chief gripe you hear is that Microsoft is pitiful in the consumer market compared with Apple. Whether this is true is irrelevant to me. Almost half of Microsoft's operating profit comes from Office, and more than 80% of Office sales are to businesses. The moat for its other primary cash cow, Windows, is about as deep as you'll find in any company. Impenetrable? No. But nothing is.
Altria's current valuations are about in line with historical averages. So why am I recommending it? Because its historic averages have made it one of the most successful stocks out there. Altria's sin-stock status and litigation threats tend to keep its valuation low, which keeps its dividend yield high. Those who consistently reinvest those high dividends have made a fortune; 155,000% return since 1970, compared with 4,500% for the S&P 500.
So you're not a fan of Gap clothes? I hear you, brother. And you think the retail sector is a joke? I'm with you there, too. But every time I look at Gap's business, I'm impressed. Granted, I'm impressed in the same way that I'm impressed with a dog that can shake on command -- really low expectations. Gap's growth seems dead. But shares are priced for exactly that. Add in a debt-free balance sheet and consumer sales that actually appear to be on the mend, and there's reason for optimism.
I'll sum up my unabashed love for payroll processor Paychex in three lines:
- It has a niche clientele. Paychex focuses on small- and medium-sized businesses. Let larger rival ADP take the big corporations. They're high-maintenance anyway.
- It takes care of shareholders. This is a cash-flow-heavy business, and management has a solid history of returning that cash to investors via dividends.
- It's double leveraged to a recovery. Not only will Paychex benefit as the economy recovers and employment rebounds, but also as interest rates move higher, since the fixed-income profit it earns on deposits held for customers will grow.
I don't care much for focusing on sectors, but everywhere I look, tech constantly looks cheap. Part of this is likely market psychology. Tech has rebounded nicely because it does an inordinate amount of business overseas, and because businesses are investing in technology that makes them more efficient, yet the market is still stopped in a recessionary mindset.
Take Intel. It currently trades at one of the lowest valuation multiples it's ever seen -- 11 times forward earnings with a 3% dividend. That dividend, incredibly, matches the yield on 10-year Treasury bonds. If the company paid out 70% of free cash flow, it'd have a dividend yield over 6%. Absurd.
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Fool contributor Morgan Housel owns shares of Microsoft, Altria, and Paychex. Intel, Microsoft, and Paychex are Motley Fool Inside Value selections. Apple is a Motley Fool Stock Advisor recommendation. ADP is a Motley Fool Income Investor selection. The Fool owns shares of and has bought calls on Intel. Motley Fool Options has recommended buying calls on Intel. Motley Fool Options has recommended a diagonal call position on Microsoft. Motley Fool Options has recommended a written covered straddle position on Paychex. The Fool owns shares of Altria Group, Apple, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.