The Values Are Hiding in Plain Sight

I am always puzzled when I hear people say things like, "Mid-cap energy stocks look attractive," or "Investors should avoid REITs right now." Perhaps it is the case that every mid-cap energy stock is undervalued, and every REIT is overvalued, but that is an extremely unlikely scenario.

Instead of making sweeping statements, I am much more interested finding undervalued stocks, regardless of whether the company is classified as health care, industrial, large cap, or small cap. However, in my search for stocks for the Morningstar GrowthInvestor newsletter, I have noticed an interesting pattern: Many high-quality technology stocks are selling at very compelling valuations.

The following six stocks covered by the Morningstar technology team are or were recently rated 5 stars:  Dell ,  Symantec (SYMC),  Maxim Integrated Products ,  CDW ,  EMC , and  Microsoft (MSFT).

Some may consider this list a collection of yesterday's hot growth stocks, and that is correct. None of these companies will grow like they did in the 1990s, but that does not mean they will grow at the rate of inflation. As you can see from the chart below, Morningstar's analysts expect these six companies to increase earnings nicely over the next five years. Investors looking for businesses with good growth opportunities, solid competitive advantages, high returns on capital, and pristine balance sheets should seriously consider these six stocks.

Six Tech Stocks Worth Considering
	EV/FCF	Market Cap ($Bil)	5-Year Est. Oper. Inc. Growth (%)	5-Year Est. ROIC (%)
Symantec (SYMC)	12.3	16.8	30.1	11.2
Maxim Integrated	16.6	10.6	12.9	43.8
CDW	15.5	4.6	12.2	32.2
EMC	12.9	27.0	17.5	20.6
Microsoft (MSFT)	13.7	243.0	12.0	78.4
Dell	10.1	56.0	9.7	NMF
Data through 06-29-06

In the second column of the chart, I have calculated the ratio of enterprise value (EV) to free cash flow (FCF) for each stock. EV is a company's equity market capitalization plus debt minus cash. FCF is the company's cash flow from operations minus capital expenditures. For example, Maxim has $1.3 billion of cash, no debt, a market capitalization of $10.6 billion, and generated $561 million of free cash flow over the last 12 months. Therefore, its enterprise value is $9.3 billion ($10.6 billion market cap plus $0 debt minus $1.3 billion cash) and its EV/FCF multiple is 16.6 ($9.3 billion divided by $561 million).

The conceptual basis for the EV/FCF multiple is simple. If we were to purchase a company in its entirety, the price we would pay is the enterprise value. We then want to know how many years it will take to earn back our purchase price in free cash flow. Of course, this assumes that the last 12 months of free cash flow is a representative and static number, which is unlikely to be the case. Another weakness is that, like all other ratios, the EV/FCF multiple does not give us an estimate of fair value. A stock's intrinsic value can be estimated only by discounting all the future free cash flows back to the present. There is no "right" multiple that can be applied to every stock. However, the EV/FCF multiple is a quick way to assess the relative attractiveness of a large number of stocks. All other things equal, the lower the multiple, the better.