Investing in stocks based on value analysis is generally considered one of the best practices. In value investing, investors pick stocks that are usually cheap but fundamentally sound. Certainly, chances are high that these stocks will allow investors to reap profits when the market trends are favorable. The strategy is very simple – find stocks that are trading below their inherent worth.
Warren Buffett once said, “It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
There are a number of ratios to identify value stocks but none alone can conclusively determine their 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. Then again, cash flow is quite reliable. Net cash flow 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. 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 stocks that qualified the screening:
Quanta Services, Inc. (PWR - Free Report) , which provides specialty contracting services, has an expected EPS growth rate of 14.5% for 3-5 years. This Zacks Rank #1 company delivered positive earnings surprises in the last reported quarter. You can see the complete list of today’s Zacks #1 Rank stocks here.
Alexion Pharmaceuticals, Inc. (ALXN - Free Report) , which develops and commercializes various therapeutic products, has an expected EPS growth rate of 14% for 3-5 years. This Zacks Rank #2 company’s bottom line outperformed the Zacks Consensus Estimate by 12.5% on average in the trailing four quarters.
Jazz Pharmaceuticals plc (JAZZ - Free Report) is a biopharmaceutical company. This Zacks Rank #2 company has an expected EPS growth rate of 11.3% for 3-5 years. The company’s bottom line outperformed the Zacks Consensus Estimate by 16.5% on average in the trailing four quarters.
Changyou.com Limited develops and operates online games in the People's Republic of China. This Zacks Rank #2 company has an expected EPS growth rate of 36.5% 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.