We recently surveyed cash flow ratios for the stocks we follow and discovered there are still good buys available. We’ve selected two stocks trading below our acceptable price-to-cash-flow ratios which we think are attractive buys for long-term growth.
If you evaluate companies on a cash flow basis, you’ll often make profitable investments. With cash flow ratios, it doesn’t necessarily matter if markets trade at highs or lows because cash flow helps detect efficient, high-quality companies that usually provide investors with above-average returns.
Sure, stock picking was easier in the early years of this decade when the world was emerging from the financial crisis. Back then, stock multiples were lower.
In March 2009, the S&P/TSX Composite Index sunk to a low of 7,566.94. Since then, it has gained 116 per cent to a recent close of 16,349.44. Nearly nine years later, stock prices have reached historical highs, thanks to a more robust global economy. And it looks like novice investors are moving into the market to participate in the latest investment fads such as tech and marijuana stocks and cryptocurrencies. In short, investors have bid the prices of stocks up to the point that many equities are no longer as cheap as they were following the financial crisis.
3 cash flow ratios we considered
Our cash flow study is important for a simple reason. Cash flow measures a company’s ability to manage its daily operations. Without cash flow, managers would have to spend a lot of their time dealing with bankers instead of clients.
We recently surveyed the companies we follow and selected two that are attractive in terms of their cash flows. To arrive at our selections, we considered, among other factors, these ratios in our survey:
1) Price-to-cash flow. Since this is a key ratio among professional investors, we use it in the industry survey in our regular Back Page feature. Price-to-cash flow is calculated by dividing the stock’s price by its cash flow per share.
Unfortunately, there’s no hard-and-fast rule for judging price-to-cash-flow ratios. These ratios often vary with the company and industry sector. In general, though, the lower the better. One rule of thumb suggests a multiple below 5.0 indicates a company may be undervalued.
Note, however, that in the US, that figure might be better at 10 times, because US companies tend to be larger and there are more investors and shares to trade.
Regardless, the rule of thumb is to try to purchase stocks when they trade below 5.0 times (10.0 times in the US) and sell when they trade above 10.0 times (20 times in the US).
2) Debt-to-cash flow. This ratio measures how well a company manages its debt. It’s calculated by dividing outstanding long-term debt by cash flow. A number below two is preferred.
3) Free cash flow. This is the amount of cash left over after dividend payments and capital expenditures. If the company has a cash shortfall, it will need a line of credit from its banker. This results in greater interest expenses and lower earnings per share.
Here are two stocks that are cash flow bargains
■ Oil and gas stock Enerplus Corporation (TSX—ERF) is a crude oil and natural gas exploration and development company that operates in western Canada and the US.
The shares, which traded as high as $27 in 2014 when the price of West Texas intermediate oil fetched US$110 a barrel, slumped with the meltdown in oil prices. After hitting a low of around $2.70 in early 2016, the stock has partially rebounded, but still offers good value.
Enerplus’ cash flows have improved with the recovery of oil and gas prices since 2016. Cash flow, which was -$4.91 a share in 2015, rebounded to $3.03 in 2016, and is projected to rise to $3.30 in 2017.
In addition to higher commodity prices, the company’s results benefitted from restructuring efforts, production growth and a strengthening Canadian dollar in 2017.
Management has strengthened its business, particularly in North Dakota, where production rose about 60 per cent in the first nine months of 2017.
The stock trades at around 3.5 times Enerplus’ projected 2017 cash flow of $3.55 a share. We consider it an undervalued stock to buy at less than five times projected cash flow. The low valuation probably reflects investors’ skepticism over how high energy prices will rise in the near term. But, even assuming a modest rise in prices over the next few years, the company should be able to continue increasing its cash flows.
Meanwhile, Enerplus pays an annual dividend of $0.12 a share, which yields about 1.0 per cent.
Enerplus is a buy for above-average growth and modest income if you don’t mind high volatility and the risk associated with this type of price action.
■ Manufacturing stock Magna International (TSX—MG) is an automobile parts supplier. Its products include chassis, interior, exterior, seating and powertrain.
The shares have advanced strongly from the $55-level of a month ago. Nonetheless, we still consider them undervalued. One thing that has kept the stock from performing better is a slowdown in sales in the US auto sector. Despite concerns that auto sales have peaked, they remain strong enough to suggest a positive outlook.
Indeed, Magna’s financial results were better than expected in the third quarter, thanks to a strong showing in emerging markets, efforts to keep costs down, and a decrease in the company’s effective tax rate. Cash flow per share, which was US$5.23 in 2016, is expected to rise to $5.95 in 2017.
The stock trades at about 6.1 times the C$12.09 a share that Magna will likely earn in cash flows in 2018. This is above the multiple of five times we suggested for an undervalued stock. But perhaps a multiple of less than 10 times would be more suitable given the company’s large US and international presence.
At any rate, we consider the stock undervalued at less than eight times cash flow. The annual dividend of C$1.36 a share, meanwhile, yields 1.8 per cent. Magna is a buy for growth and some income.
This is an edited version of an article that was originally published for subscribers in the January 19, 2018, issue of The Investment Reporter . You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter .
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