These Stocks Are Cheap by Many Measures

Most investors have their own pet metric for ferreting out when a stock is cheap enough to buy: Some use price/earnings, dividend yield, or PEG ratios. My favorite shorthand metric to determine whether a stock really is dirt cheap is price/cash flow. Specifically, I think that stocks trading at or below 10 times cash flow are dirt cheap. I figure that, since you mostly can't fake cash flow, a low price multiple of cash flow means one of two things: The company is in real trouble and the cash flow might not be there much longer (I try to avoid investing in these), or the company's stock is really cheap, and eventually that cash flow will be distributed to shareholders or reinvested on their behalf.

By combining a pet metric with other corporate and financial indicators, investors can narrow the field of ideas for research and possible investment. When several methods point in the same direction (provided they are not redundant), it's more likely you've found value than not. I've created a  simple screen that combines my pet metric--stocks trading at or below 10 times free cash flow, with the Morningstar Rating for stocks, which reflects the discrepancy between a company's stock price and our analysts' fair value estimates, as well as our assessment of the strength and predictability of the company's business. In our system, the better the business and the cheaper the stock, the more stars it gets.

I view multiples as shorthand for a more detailed projection of sales, earnings, or cash flow. Here's why. Stock certificates represent a claim on all the future earnings of the firm (after taxes, interest, and any preferred dividends). Most companies' charters provide stocks an indefinite life, and most are in no imminent danger of liquidation or dissolution. Therefore, we can think of the earnings as a perpetuity--that is, a stream of earnings or cash flow that stretches indefinitely into the future.

Moreover, we hope that the companies we invest in will grow those profits at the rate of inflation or GDP growth at the very least, say 3%. Therefore, we can think of the stream of earnings attached to stock that we buy as a growing perpetuity.

Finally, in order to calculate the value today of all those future earnings, we apply a discount rate to all the future periods' earnings to compensate us for the risk of waiting around. Most investors use some measure of their opportunity cost of waiting around for an endeavor of similar risk; at Morningstar we use our calculation of the firm's weighted average cost of capital, which, in turn, derives from its cost to raise debt financing and other fundamental factors that reflect the risk of its business.

The general formula for a growing perpetuity is P=E/(r-g). In this equation, P represents the price or the sum of all the future discounted streams, E, discounted at the rate r (also known as the required return), growing at g percent per year. So why is my favorite metric 10 times cash flow? The answer is quite simply this: When I run such a ratio through the above formula, I can reassure myself that even using conservative assumptions, I'm getting a decent value. Put another way, the stream I'm valuing hardly has to do anything in the way of outperforming my expectations for me to like the outcome.

If we plug a discount rate of 13% (by most peoples' lights this could represent the risk of a stock with a beta of almost 2--quite risky and a handsome annual return) and a growth rate of 3% (very tame, approximating GDP growth or inflation), we get P=E/(0.13-0.03) or P=E/0.10. That further simplifies into P/E=10. You can use the equation for any discount rate or growth rate, as long as the growth rate is not greater than the discount rate. In that case, this formula can't help you, and that's where P/E ratios of 400 come from, but that's another story.

When I screen for stocks trading at 10 times earnings or cash flow, in my mind I'm discounting the stream at 13% and assuming it only grows 3% forever. The same discount rate and a 5% growth rate results in a 12.5 times multiple. As of June 30, the S&P 500 traded just shy of 20 times aggregate earnings (19.75, according to Standard & Poor's), which could translate into a discount rate of 13% and a perpetual growth rate of 8%, or a discount rate of 8% and a growth rate of 3% (any combination that results in 0.05 in the denominator of the formula above would result in a multiple of 20). It's vital to remember that nothing grows at the same percentage every year forever, and that multiples can translate into many combinations of assumptions. Hence, multiples are shorthand--a simplified model. By using them to interpret the valuations inherent in the Morningstar ratings, I am performing a numerical gut check to see if I think the stock is really cheap and worth researching further.

Because Morningstar's fair value estimates are based on a projection of free cash flow, as is my pet metric, this screen allows me to combine my metric with the other features of the Morningstar Rating, specifically analysts' evaluation of companies' economic moats and the stability of their business, which influence the rating. If I were to screen on my metric and the price/fair value estimate ratio, I would be using effectively redundant metrics, and I would not learn anything from the exercise.

As it happens, the screen returns eight companies. Three of these also appeared in Haywood Kelly's column about valuable volatility:  Solectron ,  Dollar Tree Stores (DLTR), and  Sabre Holdings . The list has its blemishes, which should come as no surprise, since these stocks are dirt cheap: None of the companies passing the screen has a wide moat, for example, and, like many things on the markdown rack, more than a few have a cloud hanging over them.

Since the screen focuses on cash flow, I would probably sort the results by dividend yield, and investigate the prospects in declining order because firms that pay dividends have at least committed to returning their cash flow to investors. Sorted by dividend yield,  Cemex (CX) comes to the top, which is a stock I already own. (Note: Data is as of Aug. 2.)

Cemex SA de CV ADR (CX)
Morningstar Rating: 5 Stars
Business risk: Average
Economic moat: Narrow
Dividend yield: 2.50%
From the  Analyst Report: "Cemex has turned a commodity business into a well-insulated and highly profitable franchise in its home market of Mexico.... Cemex now has the opportunity to apply its superior operating systems--including a world-class energy strategy--to improve the struggling portions of (recently acquired) RMC's businesses."

Lear (LEA)
Morningstar Rating: 5 Stars
Business risk: Average
Economic moat: None
Dividend yield: 2.14%
From the  Analyst Report: "One of the stronger firms in our auto-parts supplier coverage universe, Lear should continue to benefit as new-car buyers demand a level of luxury, technology, and functionality in car interiors that would have been nearly unimaginable a decade ago."

Sonic Automotive (SAH)
Morningstar Rating: 5 Stars
Business risk: Average
Economic moat: Narrow
Dividend yield: 2.04%
From the  Analyst Report: "All in all, the business fundamentals of car dealerships are solid. Sonic is one of the biggest, which could be a slight edge. But, while we see no specific evidence of malfeasance, the corporate governance and clouded acquisition accounting make us a bit wary."

Sabre Holdings 
Morningstar Rating: 5 Stars
Business risk: Average
Economic moat: None
Dividend yield: 1.3%
From the  Analyst Report: "We believe that much of Sabre's long-term value comes from Travelocity, and we're confident in the online agent's prospects. Recent performance has been inspiring: Travelocity is on pace for its second straight year of 25%-plus revenue growth, and as the business becomes a bigger piece of the Sabre pie, the company's overall margins should expand."

Note: The stocks mentioned above passed our screen as of Aug. 2. The results of the screen may change due to daily price fluctuations or other factors. After clicking, you can save the search to use later by clicking the "Save Criteria" button in the bottom right-hand corner of the screen. (You will need to be logged in as a Premium Member to view and save the complete screen.)