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 metric I 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 rely on assumptions. No metric holds everything you need to know.
This one 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 debt holders.
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, get 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 four companies I found that look attractive.
Enterprise Value/ Unlevered FCF
CAPS Rating (out of 5)
Source: Capital IQ, a division of Standard & Poor's.
Let's say a few words about these companies.
If there is an Internet/technology bubble, it's contained to the newcomers. While LinkedIn
Apple, for example, generated more than $11 billion in operating cash flow last quarter, but its market capitalization of $365 billion implies tepid growth at best. And with $76 billion of cash in the bank, the implied value placed on Apple's future earnings is even lower. By nearly any metric, Apple's valuation is below the market average.
This, of course, for a company with a cult following and forecasts of 22% growth for the next five years -- forecasts that are constantly blown away. I've written that this valuation puzzle is at least partly caused by Apple's lack of dividends (or buybacks), but that could change in the future -- especially if laws regarding repatriation taxes are solidified.
It isn't hard to find nasty things to say about HP. It's a lowly box-maker. PC growth is dropping. Its former CEO is now at major competitor Oracle
But bad news can be overcome by valuation. I think that's the case with HP. The company still generates about $9 billion a year in free cash flow, which yields more than 10% against its $85 billion enterprise value. Based on three-year average share repurchases and current share prices, HP will repurchase its entire market cap sometime in the next decade. One doesn't have to argue that HP is a good company, just that its valuation puts the odds of success in investors' favor.
Home Depot's business is driven by the construction market. The construction market is derelict. Why recommend its stock?
Because construction is cyclical, and I'm convinced we're at or near the bottom of the cycle. Current housing construction is a fraction of what's needed to keep up with long-term household formation. It's low because excess housing supply is being soaked up. Most of it should be gone in another year or two. When it is, watch -- construction will ramp up significantly from current levels. New home construction should come in at less than 600,000 this year. A recent Harvard study analyzing household formation figured that number will need to average 1.7 million over the next decade to keep up with population growth. Those with patience who pick up high-quality housing stocks today probably won't regret it three years from now.
McKesson is one of the oldest companies in America, with roots dating back decades before the Civil War. One of the biggest players in the medical distribution business, it's at the center of a world that guarantees three things: death, taxes, and high medical bills.
The company has been a cash cow lately, generating more than $2 billion in free cash flow for each of the past two years. A lot of that cash has gone toward share repurchases; shares outstanding have declined more than 17% during the past five years. A good company at a good price with management devoted to shareholders rarely ends in disappointment.
Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Apple and Oracle. Motley Fool newsletter services have recommended buying shares of Apple, Home Depot, and McKesson. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. 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.