To create this list we started with a universe of the 200 largest companies by market cap. We then identified the most profitable ones on the basis of trailing-12-month gross, operating, and pre-tax margins compared to their industry average.
Next, to find companies considered undervalued, we identified the names with the highest levered free cash flow to enterprise value ratio. We were left with the six stocks detailed below.
Interested in exploring the implications of these criteria and why they can be valuable tools in finding profitable and undervalued companies? Let's review:
Market capitalization (market cap): Market capitalization, commonly referred to as market cap, is the total market value of a company's outstanding shares. It can be thought of as a measure of company's size. It can be calculated by multiplying the number of shares by the current price of the shares. Companies with higher market cap are considered to have more trustworthy information because they have greater histories of profitability and data.
Trailing 12 months (TTM): An indication that the calculated data has come from the last 12 months.
TTM gross margin: This metric that tells us the percentage of a company's revenue is left after paying all production expenses. Costs include overhead, payroll and taxation. ((revenues-cost of goods sold) / Revenue ) *100 = Gross margin %
TTM operating margin: This tells us the percentage remaining after all operating expenses are paid. Operating expenses include: supplies, repairs, research and development, and depreciation. (Operating Income / Net Operating Revenue) *100 = Operating Margin %
TTM pre-tax margin: A company's earnings before taxes. This incorporates all of the expenses associated with business excluding taxes. It can help to determine the overall operating efficiency of the firm. The higher the pre-tax margin, the more profitable the company. (Net profit before taxes / net sales) *100 = Pre-tax Margin
Levered free cash flow is a calculation of the amount of cash that a company holds after it has paid taxes, repayments on its debts, and any expenditures to maintain or expand business (Capital Expenditure or CapEx). In other words, levered free cash flow is the money that the business can use to grow and pay dividends to shareholders.
Enterprise value is an alternative measure of a company's value (instead of using market cap). Theoretically, it is the cost of taking over a company, calculated as market cap plus debt and liabilities minus cash. For example, if Company A were to buy 100% of Company B, it would need to buy all the outstanding shares, the value of which is the market cap. Company A would then be stuck with any debts and liabilities that Company B had. But Company A would also get all of the cash that Company B had in the bank, which would help pay off the debts, etc.
Because cash is an important asset for a company (it allows them to buy new machines, hire more people, etc) and because it is hard to lie about how much cash a company has, a company that holds more cash is seen to be of better value.
The levered free cash flow to enterprise value ratio (LFCF/EV) is one method of measuring the value of a company. The more free cash a company has relative to its enterprise value (a high ratio), the cheaper the company appears.
Do you think these companies are undervalued? Use the following information as a starting point for your own analysis.
List sorted by market cap. (Click here to access free, interactive tools to analyze these ideas.)
2. Cisco Systems
5. UnitedHealth Group
6. Time Warner
List compiled by Eben Esterhuizen, CFA.
Interactive Chart: Press Play to compare changes in analyst ratings over the last two years for the stocks mentioned above. Analyst ratings sourced from Zacks Investment Research.
Kapitall's Becca Lipman and Eben Esterhuizen do not own any of the shares mentioned above. Profitability data sourced from Fidelity. LFCF data sourced from Yahoo! Finance. All other data sourced from Finviz.
The Motley Fool owns shares of UnitedHealth Group. The Fool owns shares of and has created a bull call spread position on Cisco Systems. Motley Fool newsletter services have recommended buying shares of Statoil A, UnitedHealth Group, Pfizer, and Cisco Systems. Motley Fool newsletter services have recommended creating a diagonal call position in UnitedHealth Group.
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