Stocks had moved closer to the bargain zone in August’s crash, judging by value ratios for many stocks that have qualified as total-return leaders over the past five years.
“Value” is what investors prefer in difficult times such as these. This means quality stocks: large companies with stable stock market performance.
“Value” has a variety of meanings, including low debt and high cash balances. The value measurements considered here, though, are book value, cash flow and profitability.
Clients using such measurements will look for book values close to — or below — stock price, cash flow covering capital spending and dividends, and a relatively strong measure of profitability.
Of the 36 stocks analyzed as total-return leaders in the August issue of Investment Executive, most now trade between book value and twice book value. (See accompanying table.) A baker’s dozen are trading below 1.4 times book value — the cut-off point favoured by Benjamin Graham, the guru of value investing.
Real bargain time in the market, though, is when many stocks are trading very close to or below their book values. But the ratios shown by most companies in the table do indicate a much lower risk level now exists for buyers.
Measured against tangible book value (shareholders’ equity minus goodwill and intangibles), the picture is not as pretty. Many companies carry huge amounts of goodwill on their books — notably, in the financial sector, with Power Corp. of Canada being the outstanding example.
That should not hurt their stocks. Book value, excluding goodwill, is always a useful measurement for financial services companies. Tangible book value has more significance in other sectors.
In the current business and investment climate, the ability to generate cash is important — especially to produce more than enough cash to cover capital-spending needs and dividend payments.
This measurement, also known as “discretionary cash flow,” reveals a weakness among some total-return leaders. Three-year average cash flow per share figures are used in this analysis, on the basis that an average of recent results is more likely to resemble future results than a single year’s results.
Note that banks often have negative cash flow after their lush dividend payments and minute amounts of spending on hard assets. With other businesses, though, the lack of discretionary cash flow should prompt further research.
The first questions to consider: will recent capital spending produce higher sales or greater efficiencies in the future? Will capital spending needs be lower in the next couple of years?
Stocks trading at a low multiple of discretionary cash flow deserve attention. An important consideration is whether this reflects lessened growth prospects.
The ability to generate a good return on capital is another basic measurement to consider in investment decisions to buy, sell or switch. Again, the table shows average return on equity for the past three fiscal years, to smooth the results for a bumpy period.
An acceptable ROE is somewhere in the teens. Anything above that is exceptional; average ROE in the single digits may indicate problems if economic growth stalls. IE
Market turmoil hits stock valuations
Real bargains in the market are found when many stocks are trading very close to or below their book values
- By: Carlyle Dunbar
- August 29, 2011 October 31, 2019
- 12:31