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 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 the 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, get a dime. Focusing solely on profits and equity can be 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 that look attractive.
Enterprise Value/ Unlevered FCF
CAPS Rating (out of 5)
Source: S&P Capital IQ.
Let's say a few words about these companies.
Small-cap stocks outperformed large-cap stocks over the last 10 years, and for good reason: Ten years ago, small companies were cheaper than larger ones. Today, it's flipped, with some of the largest companies in world also being the cheapest. Oracle is a good example. Dominant, well-managed, and guarded by a moat, Oracle trades at a valuation well below the market average. Going forward, investors will likely get what they pay for: returns well above the market average.
Microsoft is similar. I've recommended the software giant several times over the last three years, and see no reason to change course. The company wisely cranked up its dividend payout last fall, likely helping to fuel a 25% rally. Yet shares still look like a bargain, trading at around 10 times free cash flow -- and this for a company with a fortress balance sheet and more cash than it knows what to do with. Depictions of Microsoft as a dying relic are overblown; the company's finances and earning power are stronger than ever.
The pharmaceutical industry went from one of the most popular and richly valued a decade ago to one of the most ignored and cheapest today. When attitudes flip from exuberant to exhausted, opportunity presents itself. Bristol-Myers Squibb offers one of the highest dividends among large-cap stocks in the market, trades at just over 10 times cash flow, and should at least maintain earnings power over the coming years. No lights will be blown out owning this company, but even mediocre businesses can generate good results if the price is right. And for Bristol-Myers, it is.
The story for UnitedHealth is simple: The company is large, has pricing power, is riding an ever-growing boom in health care and an aging population, and trades at a favorable price. Even after a sharp rally, shares still look attractive. Shares have doubled since 2009, but so have normalized earnings. A growing industry at a good price is a rare -- and wonderful -- combination.
Hewlett-Packard shares tumbled last week after earnings disappointed. But keep in mind how silly things have become: Even after dampened outlooks and downgrades, HP shares still trade at 6.5 times forward earnings estimates. Current earnings estimates could end up being 50% too optimistic, and HP shares would still trade below the market average. This is when investing gets interesting: When really bad, worst-case outcomes leave shares attractively valued.
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Fool contributor Morgan Housel owns shares of Microsoft. His latest e-book, 50 Years in the Making: The Great Recession and Its Aftermath, can be purchased on Amazon for your Kindle or iPad. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Oracle and Microsoft. Motley Fool newsletter services have recommended buying shares of UnitedHealth Group and Microsoft. Motley Fool newsletter services have recommended creating a bull call spread position in 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.