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.
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
CAPS Rating (out of 5)
Johnson & Johnson
Source: Capital IQ, a division of Standard & Poor's. ^Five-year average, since MasterCard went public.
Let's say a few words about these companies.
Johnson & Johnson
You probably already know about Johnson & Johnson's woes. It's working through a wave of recalls that threaten the prestige of its brand name.
History shows these episodes eventually blow over. If you're still worried, consider this. Most of J&J's recalls have come from its consumer products division. This is also where brand name prestige is most important. Thankfully, consumer products only make up a fairly small portion of the entire J&J organization:
% of 2010 Revenue
|Medical devices and diagnostics||40%|
Source: Capital IQ, a division of Standard & Poor's.
J&J is cheap by the numbers. That much is certain. When you realize that cheapness is being driven primarily by fears over the future of the company's least-important division, the worry starts to smell like opportunity.
I've highlighted Microsoft before in this series. It deserves another mention. The numbers are that compelling. Last month, being mostly serious, I showed how Microsoft could double in price by paying all its free cash flow out as a dividend. I don't expect it to do that, but these exercises detail how much Microsoft could be -- and should be -- worth. This is a company that still has a stranglehold on its key products, is still growing at a good clip, yet trades at 10 times unlevered cash flow to enterprise value. It's not supposed to work that way, and likely won't stay that way for long.
MasterCard and rival Visa
You've already heard a million reasons why Ford is a worthwhile investment. Auto sales are bouncing back. It's making better cars. CEO Alan Mulally is a champion. Here's another reason you may not be familiar with: The auto scrappage rate -- the number of vehicles taken out of operation -- in Q4 was the highest it's been since the Cash for Clunkers program skewed results in 2009, and nearly 30% higher than the previous quarter. The recession caused households to squeeze as much life out of their old cars as possible. That frugality looks like it's reached its peak. Old cars are dropping like flies and will have to be replaced. This bodes well for car manufacturers.
The Merck thesis is fairly straightforward. Shares produce a dividend yield of nearly 5%. That dividend is well-supported, consuming just 50% of free cash flow. Worries about patent expirations are probably overblown, as earnings are forecast to increase fairly rapidly over the coming years (famous last words, but forecasts of earnings falling off a cliff because of patent expirations seem overblown). Merck is a great stock for those looking for slow, solid growth and a good, stable dividend. Don't expect much else.
Intrigued? Add any of these companies to My Watchlist.
Fool contributor Morgan Housel owns shares of Microsoft and Johnson & Johnson. Johnson & Johnson, Microsoft, and Visa are Motley Fool Inside Value recommendations. Ford Motor is a Motley Fool Stock Advisor recommendation. Johnson & Johnson is a Motley Fool Income Investor recommendation. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Ford Motor, Johnson & Johnson, and Microsoft. Motley Fool Alpha LLC owns shares of Johnson & Johnson 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.
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