Investors always try to hit the jackpot while picking stocks. But striking the right chord each time is not an easy task unless you know the trick.
When it comes to the investment market, experts consider value style as one of the most effective approaches. In value investing, investors pick stocks that are cheap but fundamentally sound. So, the chance of outperformance is high when the market moves higher.
There are different valuation metrics to determine a stock’s inherent strength but a random selection of ratios cannot serve your purpose if you want a realistic assessment of a company’s financial position. For this, we would suggest considering Price to Cash Flow (or P/CF) as one of the key metrics. This metric evaluates the market price of a stock relative to the amount of cash flow that the company is generating on a per-share basis – the lower the number, the better.
Price to Cash Flow Reveals Financial Health
Questions may arise as to why we are considering the Price to Cash Flow valuation metric, when the most widely used metric is Price/Earnings (or P/E). Well, what makes P/CF stand out is that operating cash flow adds back non-cash charges such as depreciation and amortization to net income, truly reflecting the financial health of a company.
Analysts caution that a company’s earnings are subject to accounting estimates and management manipulation. On the other hand, cash flow is reliable. It is net cash flow that unveils how much money a company is actually generating and how effectively management is deploying the same.
A positive cash flow indicates an increase in the company’s liquid assets. This gives the company the means to settle debt, shell out for its expenses, reinvest in its business, endure downturns and finally pay back its shareholders. On the other hand, a negative cash flow implies a decline in the company’s liquidity, which in turn lowers its flexibility to support these moves.
What’s the Optimum Strategy?
However, an investment decision solely based on the P/CF metric may not fetch the desired results. To identify stocks that are trading at a discount, you should expand your search criteria and take into account price-to-book, price-to-earnings and price-to-sales ratios. Adding a favorable Zacks Rank and a Value Score of “A” or “B” to your search criteria should give you even better results as they eliminate the chance of falling into a value trap.
Here are the parameters for selecting true value stocks:
P/CF less than or equal to X-Industry Median.
Price greater than or equal to 5: The stocks must all be trading at a minimum of $5 or higher.
Average 20-Day Volume greater than 100,000: A substantial trading volume ensures that the stock is easily tradable.
P/E using (F1) less than or equal to X-Industry Median: This parameter shortlists stocks that are trading at a discount or are equal to its peers.
P/B less than or equal to X-Industry Median: A lower P/B compared with the industry average implies that there is enough room for the stock to gain.
P/S less than or equal to X-Industry Median: The P/S ratio determines how a stock price compares to the company’s sales — the lower the ratio the more attractive the stock is.
PEG less than 1: The ratio is used to determine a stock's value by taking the company's earnings growth into account. PEG ratio portrays a more complete picture than the P/E ratio. A value of less than 1 indicates that the stock is undervalued and that investors need to pay less for a stock that has robust earnings growth prospect.
Zacks Rank less than or equal to 2: Zacks Rank #1 (Strong Buy) or 2 (Buy) stocks are known to outperform irrespective of the market environment.
Value Score of less than or equal to B: Our research shows that stocks with a Style Score of ‘A’ or ‘B’ when combined with Zacks Rank #1 or 2 offer the best upside potential.
Here are four of the eight stocks that qualified the screening:
General Motors Company (GM - Free Report) is a designer, manufacturer and seller of cars and automobile parts globally. The company has an expected EPS growth rate of 8.9% for 3–5 years and delivered an average positive earnings surprise of 19.7% over the trailing four quarters. Currently, General Motors carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
Dean Foods Company (DF - Free Report) , a food and beverage company, has a 12% expected EPS growth rate for 3–5 years and carries a Zacks Rank #2. The company’s average positive earnings surprise is 5.4% for the trailing four quarters.
Citizens Financial Group, Inc. (CFG - Free Report) , which operates as the bank holding company for Citizens Bank, N.A. and Citizens Bank of Pennsylvania that provide retail and commercial banking products and services, carries a Zacks Rank #2 and has an 18% expected EPS growth rate for 3–5 years. The company delivered an average positive earnings surprise of 5.3% over the trailing four quarters.
PennyMac Financial Services, Inc. (PFSI - Free Report) , which is engaged in mortgage banking and investment management activities, holds a Zacks Rank #2. The company has an expected EPS growth rate of 10% for 3–5 years.
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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.
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