These Companies Are Undervalued

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Earnings yield is a valuation method used to check if a company is over or undervalued compared to its peers and the wider market. A company's earnings yield is calculated by dividing earnings per share for the last twelve months by its current share price. The resulting figure shows the percentage of each dollar invested in the stock that was earned by the company.

The earnings yield figure can be used to calculate how over/undervalued the stock is in relation to the wider market. In particular, a company with a higher earnings yield than the wider market is overvalued, while a company with a lower earnings yield than the wider market is undervalued. In addition, if the wider market is trading with a higher earnings yield than the yield on the 10-year treasury, then stocks on the whole can be considered undervalued.

So, how does the market look?

Current S&P 500 earnings yield: 5.15%

Current 10-year treasury yield: 2.61%

Overall, the S&P 500 looks to be undervalued relative to the 10-year treasury, indicating that the market as a whole is indeed undervalued compared to the risk free 10-year rate.

What about individual companies?

Well, considering that the S&P 500 as a whole is trading at an earnings yield of 5.15%, a company with an earnings yield greater than 5.15% could be considered undervalued relative to the rest of the index.

After a quick scan of the market, it turns out that 212 stocks actually trade on an earnings yield higher than the market average of 5.15%. However, 39% of these 212 stocks trade with earnings yields of between 5.15% and 6.15%.

So, where is the most value to be found? Well, some resource stocks are actually trading at quiet high earnings yields as their prices are low and TTM earnings are still high after a strong 2012 for commodities, but so far this year, the commodity outlook has been weak. So, after discounting commodity companies and companies that rely upon commodity output for earnings, such as Joy Global, the following were the results.

The results

Seagate Technology (NASDAQ: STX), currently trading with an earnings yield of 13.3%, looks to be undervalued compared to the rest of the market and the 10-year treasury. Additionally, the company yields more than the 10-year treasury with a dividend yield of 3.3%. Earnings are expected to fall slightly next year, but this will still give the company an earnings yield of 11% (on a forward basis).

Furthermore, compared to its ten largest peers in the data storage devices sector, Seagate looks cheap trading at a TTM P/E of only 7.5 compared to the average of 20.7 and the company's peers trade with an average earnings yield of 6.3%.

Next up is D.R. Horton (NYSE: DHI), which is benefiting from the resurgence in housing activity. Out of all the home builders, D.R. Horton appears to be the most undervalued according to earnings yield, which is 13.3% for the company. Currently, the company also appears to be undervalued on a P/E basis as it is trading at a TTM P/E ratio of 7.5, while its ten largest peers in the residential construction sector trade at an average TTM P/E of 22.3.

Moreover, the ten largest companies in the residential construction sector trade at an average earnings yield of 6.6%, and interestingly enough, achieve a lower return on equity and assets than D.R. Horton on average. On average, D.R. Horton's ten largest peers achieve 8.8% return on assets and 21% return on equity, while D.R. Horton has produced a 14.5% return on assets and a 29.5% return on equity for the trailing twelve month period.

Lastly, Chevron (NYSE: CVX), a great company, and according to earnings yield, trading at a great price. Last year, Chevron earned $13.24 per share, at a current share price of $124, this equates to an earnings yield of 10.7%, indicating that Chevron is cheaper than the general market. That said, it would appear that the most of the major oil & gas sector companies are also trading at valuations that signify they are undervalued compared to the wider market.

For example, ExxonMobil has an earnings yield of 10.5% and Royal Dutch Shell has a yield of 11.9%. Still, Chevron appears to be one of the most undervalued, trading at a TTM P/E of 9.4 compared to the sector average of 11.3, and a return on equity of 19.2% compared to the sector average of 17.2%. The company also has a higher operating profit margin of 18.7% compared to the sector average of 13.4%.

Foolish summary

Earnings yield is a valuation method used to compare companies to their peers and to the wider market and bonds. According to this metric, these three companies are all undervalued and even after their recent gains, there could be some upside left. Still, even if there is no upside in the near-term, longer term, these companies present an attractive buy and hold investment while the valuation gap closes.

The best investing approach is to choose great companies that are undervalued and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.

Fool contributor Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool recommends Chevron. 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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