Editor's Choice

Is This Stock A Buy At 20% Off?

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

A 20% off sale at most retailers is enough to draw attention from shoppers. In the stock market it's no different, buying shares for 20% less in theory improves your chances of scoring a good deal. This is why on a regular basis I run a screen for companies sell for a 20% discount to their 52 week high. To run this screen I use the Fool.com CAPS Screener, and I look at each each industry separately to look for opportunities. I've been watching transportation stocks because these companies give investors insight into multiple industries. In addition, analysts generally expect solid double-digit growth from the railroads in particular. For this reason, I was pleasantly surprised to see Norfolk Southern (NYSE: NSC) come up on a 20% screen.

I've written in the past, if you want a quick way to keep up with multiple industries, look at a railroad's earnings report. Since these companies help ship the goods necessary to keep multiple industries running, you get a cheat sheet on what is going on in each sector. However, investors should look at railroads on their own merits instead of just looking at them as an economic cheat sheet. Given that the big three railroads are all expected to post earnings growth of at least 12.5% over the next few years, these stocks look attractive on their own. In addition, each of these companies pays a decent yield as well. Considering that railroads offer a cheap shipping option to multiple industries, it's not hard to understand that these companies should do well if the economy continues to recover. With Norfolk Southern selling for 20% off its 52 week high, I don't want to assume this is the best investment in the industry. Let's take a look at how the big three railroads compare and see if this discount at Norfolk Southern is an opportunity, or if the discount is warranted.

Looking at Norfolk Southern, CSX (NYSE: CSX), and Union Pacific (NYSE: UNP), they are each expected to post good growth in the next few years. The question is which stock is the best value? I look at the company's expected growth rate and dividend yield versus their projected P/E ratio to determine the best value. Using this PEG+Y ratio, the higher the number, the better value. Norfolk Southern comes in at 1.44, compared to 1.57 at CSX and 1.26 at Union Pacific. Since CSX has the highest ratio, this means the company offers the best total return relative to its forward P/E ratio. (CSX – 3, Norfolk Southern – 2, Union Pacific – 1)

Now of course using a company's yield to determine value only makes sense if this payout is sustainable. The good news for investors is, each of these companies has a payout ratio that is reasonable. Between these three companies, they have payout ratios between 30% and 60%. That being said, Norfolk Southern has the highest yield at 3.21% versus 2.84% at CSX and 2.21% at Union Pacific. With each company offering a reasonable payout ratio, the highest yield wins. (CSX – 2, Norfolk Southern – 3, Union Pacific – 1)

Another way to compare companies in the same industry is to look at their gross margins. Since railroads offer similar services, in theory the one with the highest gross margin either is more efficient or has pricing power. This is one significant weakness at Norfolk Southern, as they show a gross margin of 62.57%. Compared to a gross margin at 68.14% at CSX and 73.39% at Union Pacific, you can see that both of Norfolk's major competitors are significantly more efficient or have a better pricing strategy. (CSX – 2, Norfolk Southern – 1, Union Pacific – 3)

As one last test, we need to compare the balance sheet strength at each of these companies. Peter Lynch once said that some of the greatest losses in the market come from not understanding a company's balance sheet. I use the debt-to-equity ratio to compare companies since this gives an apples-to-apples comparison. Using this ratio, the company with the strongest balance sheet is Union Pacific at 0.45. On a relative basis, Norfolk Southern and CSX have weaker balance sheets at 0.86 and 0.91 ratios respectively. Since a stronger balance sheet means a greater margin of safety, Union Pacific takes this category. (CSX – 1, Norfolk Southern – 2, Union Pacific – 3)

Looking at the final scores, CSX comes in at 8, Norfolk Southern scores an 8, and Union Pacific scores an 8. In the end we have a three-way tie! What is particularly ironic about this is, Norfolk Southern is down more than 20% off its 52 week high, CSX is down over 16%, yet Union Pacific is down just 3.4%. Given that Norfolk Southern offers the highest yield, and one of the best combinations of yield and EPS growth, I don't see anything that jumps out to explain why a 20% discount is warranted. While it's true the company's gross margin lags its competition, this could be seen as an opportunity. If Norfolk Southern can improve its gross margin through pricing and efficiency improvements, the stock could be an even better value. This looks like a situation where Norfolk Southern is being marked down unfairly. Investors should take this opportunity to do their own research and determine if they should buy shares that seem on track for gains.

MHenage has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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