Sophisticated investors look at a company’s cash flow, not just its reported earnings. Among the stocks that look strong now based on the ratio of stock price to cash flow are Valero Energy Corp. (VLO, Financial), eBay Inc. (EBAY, Financial), and PDL BioPharma Inc. (PDLI, Financial).
To calculate earnings, you start with a company’s revenue and subtract all expenses. Some of these expenses are intangible, non-cash items such as depreciation and amortization. Say a pizza shop owner buys a dozen trucks to deliver pizzas. He may be depreciating 20% of the trucks’ cost per year for five years.
But let’s say he bought the trucks four years ago, paying cash up front, and the trucks are in such great shape that they will last nine years. In that case, his cash flow is more robust than reported earnings indicate.
Last year at this time, I recommended five companies that looked good to me based on the ratio of stock price to the companies’ cash flow. They were Barnes & Noble Inc. (BKS, Financial), Everest Re Group Ltd. (RE, Financial), Hewlett-Packard Co. (HPQ), Sony Corp. (SNE, Financial) and St. Joe Co. (JOE, Financial).
Sony did very well, up 43.8%. Barnes & Noble and Everest Re also did fine, up 18.7% and 16.6% respectively. But St. Joe and Hewlett-Packard were duds, down 18.8% and 17.6% respectively. All figures are total returns including dividends.
Averaging the returns for the five stocks produces a gain of 8.5%, edging out the return of 7.7% on the Standard & Poor’s 500 from August 19, 2014 through August 14, 2015.
11-Year Results
This is the 12th column I’ve written since 1999 recommending a few companies that look strong based on the “price to cash flow” ratio. Of the previous 11 columns, nine have been profitable and 10 have beaten the S&P 500. The average return for the 11 columns has been 27.5%, versus 7.9% for the S&P 500.
Bear in mind that the results of my column picks are theoretical and don’t reflect actual trades, trading costs or taxes. Past performance doesn’t predict the future. And the performance of my column recommendations shouldn’t be confused with returns I earn for clients on actual portfolios.
Now let’s give it another go. Here are five companies that appear to me to be bargains now. Each sells for no more than eight times cash flow and no more than 10 times “free cash flow,” which takes into account companies’ capital spending.
AU Optronics
Based in Taiwan, AU Optronics Corp. makes flat-panel display screens, and also manufactures solar equipment. Its American Depositary Receipts (ADRs) trade for about $3 a share on the New York Stock Exchange. The stock has done terribly in the five months since I recommended it on March 24, in a column on non-U.S. stocks. Yet I recommend it again today. Prices for display panels have been falling this summer. But an old stock-market adage suggests “buying straw hats in January.”
eBay
No longer considered a hot stock, eBay may now be a bargain. The San Jose company uses the Internet to bring together buyers and sellers of a wide variety of goods. It has notched a profit every year since it went public in 1998, and seems to be rebounding nicely from a weak year last year. Shares trade for less than six times cash flow.
HCI Group
HCI Group Inc. (HCI), formerly known as Homeowners Choice, is a property and casualty insurer with headquarters in Tampa, Florida. Public since 2006, it has a streak of eight consecutive profitable years and has posted record earnings recently. Yet it sells for only 5.3 times cash flow and less than six times earnings.
PDL BioPharma
A small-cap biotech stock based in Incline Village, Utah, PDL Biopharma Inc. (PDLI, Financial) specializes in technology for “humanizing” monoclonal antibodies developed in laboratories. It licenses this technology to various drug companies. In addition, it funds medical research by other biotechnology companies, usually in exchange for royalties on future drugs.
In some ways, PDL’s model resembles that of the telecom giant Qualcomm, which makes no phones and carries no calls, but licenses its cellular technology to other companies.
Valero Energy
I’m currently sweet on refining stocks. For refiners, oil is a raw material. So the drop in oil’s price from $100 a barrel last summer to under $50 today can give a tremendous boost to refiners’ profits. One of the largest refiners, and one with an excellent price-to-cash-flow ratio, is Valero Energy Corp. (VLO, Financial), based in San Antonio, Texas. I own it for one or two clients, and I own another refiner, HollyFrontier Corp. (HFC) for most.
