This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, our headlines feature a pair of downgrades, for toolmaker Stanley Black & Decker (NYSE: SWK) and electrical equipment maker EnerSys (NYSE: ENS) alike. But the news isn't all bad, so before we address those two, let's take a look at why one analyst thinks that...
Ford is ready to motor
Shares of Ford Motor (NYSE: F) are reacting positively to news of a new hike in price target on the stock at RBC Capital Markets this morning. Actually, the shares are racing way ahead of the market, up 2.4% already, and climbing. But is the word of one analyst really a sound basis to be bidding up Ford shares?
Maybe not. But here's something you can rely on: cold, hard facts.
Facts like Ford's 10.8 price to earnings ratio, which looks attractive in light of analysts' consensus projections that Ford will grow its earnings at close to 12% per year over the next five years. Facts like Ford's generous 2.7% dividend yield. All of these numbers appear to argue strongly in favor of buying Ford. And yet... not all the numbers are so favorable to the Ford buy thesis.
The primary number that has me worried at Ford, and the primary reason I won't be following RBC's advice to buy the stock, is the fact that over the past 12 months, Ford has reported $5.9 billion in GAAP "earnings" from its business -- but produced just $1.3 billion in real free cash flow. That's a significant discrepancy, and it's not an anomaly, either. Fact is, Ford has been reporting lower cash flow from operations, for some time now, and higher capital spending. Year in, and year out -- for four years straight.
Result: At a price to free cash flow ratio of more than 48 today, Ford's stock doesn't look nearly as attractive to me as its low P/E ratio and high growth rate seem to suggest. RBC may think Ford shares are worth $18 or more. Me, I think they're worth a whole lot less than the $16 they currently fetch.
Stanley: bleak and bleaker
Speaking of overpriced stocks generating too little cash to justify their market caps, there is Stanley Black & Decker.
Stanley got hit with a downgrade to hold by analysts at Argus Research this morning, and honestly, I can't blame the bankers for their pessimism about this one. Priced north of 15.5 times earnings, and expected to grow profits at 13% annualized over the next five years, Stanley shares may not look expensive -- but just like at Ford, looks can be deceiving.
Once again, the problem we face is cash flow. Free cash flow, to be specific -- operating cash flow minus capital expenditures.
Once you net out capex from the $851 million in cash Stanley generated last year, the company's left with real free cash flow of only $447 million -- or about $0.53 on every $1 of earnings claimed on its income statement. The resulting price to free cash flow ratio of 29 may not make the stock as richly priced as Ford, but it's still too expensive for a 13% growth rate.
Meanwhile, if a 29 times free cash flow valuation is enough to make Argus cautious about Stanley, Ford investors might want to ponder the implications of their own stock's 48 times free cash flow share price.
Always end on a bright note
Fortunately, today's news isn't all bad -- not even for stocks suffering downgrades -- because I actually see a bit of hope in our third and final featured stock, electrical equipment maker EnerSys. Ardour Capital just cut its rating on the stock to reduce, which basically means sell in Wall Street speak. But is the ratings reduction justified?
On the one hand, EnerSys didn't exactly set the world on fire with its Q4 earnings release Tuesday. Earnings of $0.80 just matched analyst estimates, and revenues of $572.2 million only topped the consensus by $200,000.
Meanwhile, at 14 times earnings, and with the slowest projected growth rate of any stock so far mentioned today, EnerSys doesn't look all that cheap. If the analysts' projected 7% growth rate is the best the company can manage going forward -- and remember that profits grew only 6% in Q4 -- the company could be overpriced, and deserving of Ardour's sell rating.
On the other hand, though, EnerSys did generate $189 million in positive free cash flow last year. That's 15% ahead of reported earnings. EnerSys has also grown by leaps and bounds over the past two years, improving annual profits by a total of 45.5%, and growing free cash flow by well over 1,000%. Judging from its trajectory alone, predicting a reduction to 7% growth going forward seems overly cautious.
Then again... that is close to what the company reported for Q4 this week. While I'm optimistic that the company will continue growing as it has been, maybe a bit of caution for this strong performer is warranted after all.
Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Ford. The Motley Fool owns shares of Ford.