“It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” – Warren Buffett. The strategy is quite simple – find stocks that are trading below their inherent worth.
Investment in stocks made on diligent value analysis is usually considered one of the best practices. In value investing, investors pick stocks that are cheap but are fundamentally sound. So chances are that these stocks will allow investors to book profits when the market trends upward.
There are a number of ratios to identify value stocks but none alone can conclusively determine a stock’s inherent potential. Each ratio helps an investor to understand a particular aspect of the company’s business. One such ratio, Price to Cash Flow (or P/CF), can work wonders in stock picking if used prudently. 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.
Why Price to Cash Flow?
You must be wondering why we are considering this when the most widely used valuation metric is Price/Earnings (or P/E). Well, one of the important factors that makes P/CF a highly dependable metric is that operating cash flow adds back non-cash charges such as depreciation and amortization to net income, truly diagnosing 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 much 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 undertake shareholder friendly moves. 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 endeavors.
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 ratio, price-to-earnings ratio and price-to-sales ratio. Adding a favorable Zacks Rank and a Value Score of “A” or “B” to your search criteria should lead to even better results as these eliminate the chance of falling into a value trap.
The Bargain Hunting Strategy
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 gives a more complete picture than 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 a Zacks Rank #1 or 2 offer the best upside potential.
Here are four of the nine stocks that qualified the screening:
PennyMac Financial Services, Inc. (PFSI - Free Report) , which is engaged in mortgage banking and investment management activities, has an expected EPS growth rate of 10% for 3–5 years. The company flaunts a Zacks Rank #1. You can see the complete list of today’s Zacks #1 Rank stocks here.
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 registered an average positive earnings surprise of 19.7% over the trailing four quarters. Currently, General Motors carries a Zacks Rank #2.
Mallinckrodt Public Limited Company (MNK - Free Report) , developer, manufacturer, marketer, and distributor of specialty pharmaceutical and biopharmaceutical products, has a 9.7% expected EPS growth rate for 3–5 years and carries a Zacks Rank #2. The company registered an average positive earnings surprise of 11.2% over 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.
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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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