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Ratio helps determine if a stock is a bargain

Tribune-Review
| Tuesday, August 14, 2012 12:01 a.m

How do you know when a stock is cheap?

To make that call, you must compare the stock’s price to some measure of intrinsic value. The most popular yardstick is the price/earnings ratio, widely used by both amateur and professional investors. Another gauge, not often used by amateurs but frequently used by professionals, is the price- to-cash flow ratio.

As the name suggests, cash flow is a measure of the cash a business generates. It excludes intangibles such as depreciation and amortization.

The cash flow statement is the third of three financial statements that companies must issue every year. Everyone looks at the income statement (profit and loss). Wise investors scrutinize the balance sheet (assets and liabilities). And sophisticated investors also examine the cash flow statement.

Some focus on “free cash flow,” which subtracts from cash flow the amount a corporation spends on capital expenditures.

General Motors Corp. (GM), for example, sells for six times earnings but only three times cash flow, because it has lots of depreciation charges. It sells for 15 times free cash flow, because it spends heavily on plant and equipment. (I own GM shares for most of my clients.)

It’s been six years since I wrote a column about stocks that look cheap based on their price-to-cash flow ratio. From 1999 through 2006, I did eight such columns, one each August — a tradition I would like to revive.

My selections in those columns had an average gain of 21.7 percent, compared with 4.4 percent for the Standard & Poor’s 500 Index. Seven of the eight columns beat the S&P 500, and seven of the eight were profitable.

Bear in mind that the results of column recommendations shouldn’t be confused with the performance of real money portfolios I run. Column results are hypothetical and don’t reflect trading costs or taxes. Also, past performance doesn’t predict future results. The next set of recommendations could be a flop. But let’s give it a try.

The average U.S. stock today sells for 13 times cash flow and 29 times free cash flow. Here are five stocks that look attractive with price to cash flow below eight and price to free cash flow below 10.

JP Morgan Chase & Co. (JPM) of New York, knocked down by a recent trading scandal, is selling for less than two times free cash flow and also for less than book value (corporate net worth per share).

I think it’s a sound bank, and I believe Jamie Dimon is a good CEO, despite the black eye from a trading loss of at least $5.8 billion in the “London Whale” case.

The bank stayed profitable through the financial crisis, and posted record earnings of $4.48 a share last year. Despite the notorious trading loss, analysts look for another record this year, $4.67.

Eli Lilly & Co., one of the largest U.S. drug companies, sells for nine times free cash flow. The Indianapolis company is a good dividend play, with a yield above 4 percent. At about $44 a share, Lilly’s share price is about where it was a decade ago. Earnings per share have increased more than 50 percent in that time, and revenue has more than doubled.

EPAM Systems of Newtown, Pa. (EPAM) is a software development company. Investors don’t pay much attention to it because it is small and has erratic earnings. However, it looks appealing at 2.4 times cash flow and 2.8 times free cash flow.

Only seven brokerage houses have ratings on EPAM, and six of those are buys. I don’t usually like to run with the crowd, but the big U.S. brokerage houses don’t cover it yet, so I don’t mind so much.

National Western Life Insurance Co. of Austin sells life insurance and annuities in the United States and Latin America. Like JP Morgan, it stayed profitable through the financial crisis. It has earned a profit in each of the past 10 years.

The company is debt-free, a trait I always like. Only one brokerage house bothers to follow National Western, and that one (EVA Dimensions) rates it a sell. With the stock at 1.8 times both cash flow and free cash flow, I’d say it is a buy.

Another debt-free company is GameStop Corp. of Grapevine, Texas (GME), which sells new and used video games. Okay, this may not be the most socially redeeming company on the planet. But at four times cash flow and less than six times free cash flow, it does look attractively priced. I like it as an independent company and also consider it a potential takeover target.

John Dorfman is chairman of Thunderstorm Capital LLC in Boston. He can be reached at jdorfman@thunderstormcapital.com.

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