Using the Price-to-Book Ratio and Free Cash Flow to Find Stable Undervalued Stocks
Nihar is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
A price-to-book ratio below one means that the market has attached a discount to the assets of a company. It that for every dollar spent buying a piece of the company, the amount bought is greater than that dollar. There are various other definitions and metaphors that are apt, but the simplest explanation is that the shares of the company are on sale. However, at times the market values a company below its book value, because the book value is inflated by intangibles or mispriced assets. You might consider looking at price to tangible book value, but I believe that intangibles can have important value and I would not exclude this. Another reason for a discount is that while the assets are fairly priced, they are not being adequately utilized and are not creating enough value for the company. The ratio I look up in screeners is below 1, but sometimes you can go to 1.5 depending on the industry. A company that is undervalued relative to its peers also has potential
The second thing I might consider is free cash flow. A company might be undervalued for a reason, but free cash flow means an improving cash position. If I am trying to find a stock that is beaten down by the market waiting for a turnaround, I would rather invest in one that has the flexibility of a good cash position than one in a downward spiral. You cannot always rely on free cash flow, because a company starting an aggressive growth strategy, such as breaking into a new market, would not have free cash flow. It might still be a great long term investment if their expenditures pay off. I cast this net very low at $100M in free cash flow, because I just want it to be there. If you wonder why I am not choosing $1M or $1.00 it is because I am looking at companies with a market cap above $1B, though I set screeners to $950M and above. Below a $1B market cap, I use different metrics and analysis.
Here are two tickers that the screener spit out for me, and my initial thoughts on them. Be aware that this is a starting point, and I would dig deeper into each company before taking a position. Values all taken from ycharts.
Bank of America - Price to Book Ratio: 0.3964
Bank of America (NYSE: BAC) is probably my favorite stock with a ratio below 1, because it is I do not even have to look for it to have a ratio that goes above 1 and rises toward the dizzying heights before the credit crisis. The book value per share hovers around $20, which gives an absolute number to the ratio. The current price is less than half at $7.99.
There are a couple of reasons that the market has taken such a hatchet to Bank of America’s value. The first is the prospect of more writedowns. Most banks have already flushed tons of bad mortgages off the books. Bank of America by virtue of being one of the biggest and buying some bad banks suffers a bit more. I think the fear of the writedowns is the more serious concern for the stock price. I think the writedowns in the future will not be as severe as the market is pricing in. Then there are European concerns. The worst case scenarios of these would amount to the Earth imploding; at least if you read too many message boards you get that perspective. Europe is a concern so keep a close eye on it, but I do not the fallout will be that great. Also, I do not expect American banks to suffer as much given the time and forewarning they have had to bolster themselves against the future.
At the present Bank of America is profitable. There are a few issues looming on the horizon, but none of them are guaranteed to come to pass. All the while Bank of America is righting itself, generating a profit. The share price has stagnated. With continued growth that would make it more and more undervalued. It will only take one spark to start the share price appreciating. You would not need the current book value to see a good return. It just needs some fast appreciation in the next 2-3 years while the economy improves. After that the price can lag the book value per share and you can still see good appreciation.
I would be looking for Bank of America to have a price to book ratio of around 0.80, which would already be double from the current price. Of course I would like to get to that ratio while the company is doing well, and not have the fair value meet us down here. I will look into Bank of America to determine if it will be a good choice. Free cash flow is not a problem for Bank of America, $18B according to ycharts, nor is this one of the stocks where I would pay much attention to that metric. It is only then that I would take a position in stock, though I have other trade ideas that are not traditional buy-and-hold.
Alcoa – Price to Book Ratio: 0.5413
If you like aluminum you have got to love Alcoa (NYSE: AA), though I am not sure how many people actually love Alcoa. Alcoa is caught in the thrall of a global slump in demand. It boasts a scary Price to Equity ratio of 97.11 on ycharts, but I think that can be explained by other factors, such as only recently returning to positive earnings. That is actually a good sign, and as earnings grow we should see that number deflate. At the same time Alcoa is priced below book.
The two opposing forces in the previous paragraph show that Alcoa is a bit sooner on its path to share price recovery than Bank of America. It is also riskier, but returning to profitability means that it might be a chance to get in near the bottom for the long haul. I think this one just requires a bit more patience. The catalysts for decline or appreciation for Alcoa are very basic. If global demand picks up and manufacturing increases it will be good for Alcoa, but any stagnation or decline will eat into the company. The standard macroeconomic issues will weigh on the company. The American economy and job market, Europe and the euro, and the Chinese slowdown could all weigh down. This affects almost all stocks.
Before the credit crisis Alcoa was sporting a price to book ratio of 2 or slightly less. That is over 3 times the current value attached to its assets. There are so many factors that could determine the price of Alcoa, so do not assume the price will go according to the math. Just realize that Alcoa’s assets used to command a better price. When earnings get back on their feet we should get a better picture of where Alcoa is headed. Free cash flow is almost $250M so hopefully Alcoa is using the global slump to acquire more materials in the ground, or better smelting equipment. Not to say that it is bad, but companies with good and improving cash positions are at an advantage. Some more debt-laden companies might price their profitable assets at a tempting level for a quick cash infusion. That is all stuff I would look at further into my research.
To me Alcoa is not as easy an investment as Bank of America. However, I have been watching it for a while now, and it has been down at these levels forever. Now we are finally seeing some life in the global economy so it might be time. On the other hand there is a lot of bad data including manufacturing decline. So it might be prudent to wait, but Alcoa has not pushed much lower. It might be time soon to take a position in Alcoa. I might once I understand more about its business trajectory.
There are many other stocks that pop up when you plug these criteria into a screener. Obviously, I cannot go over all of them. These are two that caught my eye. Both are priced the way they are for valid reasons; however the result is perhaps too severe. Also, the market may not yet see business improving. With enough research you might be comfortable taking the risk, and trying to get in ahead of the broader market. The price-to-book ratio is a good place to start for those large companies, which have fallen on hard times.
Not all are necessarily a good pick. Research in Motion and Tellabs showed up on the list as well, but I am not comfortable owning these stocks. They either made bad decisions or have not kept up with the times. Not all stocks priced below their book value are a buy.
TheArchivist has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America. 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.If you have questions about this post or the Fool’s blog network, click here for information.