Value-hungry investors may be eyeing beaten-down oil service giants such as Halliburton (NYSE:HAL), and Schlumberger (NYSE:SLB) after the brutal beating these companies' shares have taken in the last six months because of crashing oil prices.

HAL Chart
HAL data by YCharts.

While that is certainly a smart strategy, I think most investors are potentially focusing on the wrong valuation metrics and thus making a mistake in terms of determining which of these companies is truly the most undervalued. 

The most popular valuation method is wrong

Company Trailing-12-Month P/E Ratio Price/Sales Free Cash Flow Margin Free Cash Flow Yield
Halliburton 10.05 1.06 5.3% 4.2%
Schlumberger 20.06 2.15 13.6% 5.9%
S&P 500 19.3     5.5%

Sources: Yahoo! Finance

Two of the most popular ways of valuing a company are with the P/E ratio and price/sales ratio. Given that Halliburton has fallen 50% more than Schlumberger in the last six months it's not surprising that based on these two metrics, Halliburton seems much more undervalued, as seen in the above table. 

However, most investors fail to consider a company's free cash flow, or the cash coming into a company that is left over after all expenses and investments in future growth have been made. Free cash flow, or FCF, is important because this is what gives a company the ability to pay back shareholders, either in share buy backs or, my favorite method, dividends. In addition free cash flow is unaffected by one-time charges that can make earnings swing wildly, and thus is a more stable method of valuing a company's operations.

Why Schlumberger is actually more undervalued 
My favorite method of using free cash flow to value a company is with free cash flow yield, or FCF divided by enterprise value -- (market capitalization plus debt minus cash). FCF yield is a way of predicting your potential return on your investment in the company's core business based on the corporation's previous year's cash flow. It can also tell you how long it would take to be paid back by a company's free cash flow, assuming that free cash flow remains constant. In the case of Halliburton and Schlumberger, that payback period is 24 and 17 years, respectively. 

How can Schlumberger, who's trading at a premium to Halliburton by several metrics, actually be more undervalued? The answer lies in the fact that Schlumberger's fcf margin, or the percentage of sales converted to free cash flow, is more than double Halliburton's. In other words, Schlumberger, the world's largest oil service provider, is able to use its enormous size to maximize its economies of scale, as well as its larger presence in the higher profit international market, to convert revenue to free cash flow much more efficiently. 

Merger could change everything
So, am I saying you should run out and buy Schlumberger instead of Halliburton? Not exactly. Halliburton recently announced plans to buy rival Baker Hughes (NYSE:BHI) for $34.6 billion in cash and stock. This is important because Halliburton's management is confident that it can get the deal approved by regulators with a minimum of divestitures of current assets, which would make Halliburton the world's new largest oil services provider in terms of sales. 

In addition, Halliburton believes that, once the two companies are fully integrated by the end of 2017, it will be able to achieve $2 billion in synergistic cost savings. 

Source: Baker Hughes investor presentation.

These cost savings could directly increase Halliburton's free cash flows and potentially greatly increase its FCF margin. In addition, through much larger economies of scale, Halliburton would likely have increased pricing power with both suppliers and customers. That means once oil prices recover, Halliburton's margins, including FCF margin, could grow even larger than the initial $2 billion in cost savings suggest. These much higher margins mean Wall Street might grant Halliburton a much higher valuation, causing shares prices to potentially greatly increase in value.

Bottom line: Keep free cash flow yield in mind when considering valuation
Don't get me wrong: I think both Halliburton and Schlumberger make excellent long-term dividend growth stocks, especially after getting crushed in recent months. At the moment, Schlumberger is much better at generating free cash flow than Halliburton, and I consider it the more undervalued company. However, this might change depending on how well Halliburton is able to maximize its new economies of scale once its merger with Baker Hughes is complete.  

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.