Here’s a Different Way to Value Stocks and Find Great Buys
You know who has a lot of it?
Corporations like Berkshire Hathaway (BRK.A) and Apple (AAPL) have GOBS of cash.
Institutional investors like private equity firms had $3.1 trillion in “dry powder” in February 2021.
The Federal Reserve’s efforts to boost the economy have fueled a trickle-up effect.
The trillions in stimulus money have cycled into the cash column on the balance sheet of Corporate America. It doesn’t take long. And now, there’s chatter about the best way that a company can return all that cash to its shareholders.
Corporations can return this money to their investors in a number of ways. They can increase their dividend and return that money on a quarterly basis over time or in the form of a one-time special dividend paid at their discretion.
They can do it even faster by buying back their own stock. Buybacks reduce the number of outstanding shares available and in turn increase the value of shares sitting in their investors’ accounts.
There’s another way they can return money in the form of value: through mergers and acquisitions. Companies can buy out smaller rivals or strategically aligned companies, boost the enterprise value of their firms, and create new business lines and synergies that return larger gains over the long term.
But how does one even know where to start when looking for target companies?
Not only do I have that answer, but I’ve also identified the types of companies that are attractive right now.
Let’s dig in.
Buybacks Versus Buy Ups
This year, companies are awash in cash.
This massive hoard across Corporate America has Goldman Sachs predicting a busy year for stock purchases. The investment bank predicts that stock buybacks will increase by 30% in 2021. The bank expects another 5% increase next year.
This story generated a lot of headlines on CNBC and other sites. The stories of Berkshire Hathaway, Apple, AMD, DuPont, and more fueled a lot of optimism.
But buybacks only offer a short-term boost to the stock.
Where is the real opportunity for the company to grow instead of manipulating its balance sheet for short-term gains?
Mergers and acquisitions deliver real value over time when done the right way. A solid merger can provide long-term sustainability and new profit avenues. Of course, the COVID-19 pandemic set the brakes on deal-making in 2020.
According to a study by WilmerHale, the number of M&A deals around the globe fell from 48,613 deals in 2019 to 45,507 in 2020 (a 6% decline). The same study said that total M&A deal value declined from $3.35 trillion to $2.83 trillion (a 15% drop).
Finally, the average deal size dropped from $68.9 million in 2019 to $62.3 million last year (nearly a 10% drop), according to the same study.
However, the negative trend has reversed. Deal-making has been fast and furious over the start of 2021. Refinitiv says that an all-time record for M&A transpired over the first four months of the year. The company says that total deal-making reached $1.77 trillion through April. That’s a 124% increase year-over-year and represents a 10% increase compared to the all-time record for that period.
With this amount of buying already underway, we can start to look for companies that might be attractive takeover targets – OR companies that activist investors might target to squeeze greater value out of the firm (and position it to sell to the highest bidder).
Let’s look at a simple metric that shows us which companies might be cheap targets.
Why Enterprise Value to EBIT
We want to look at a very specific formula to give us an ability to judge different companies from different sectors with different tax structures on a 1-to-1 level.
We start our research with a company’s enterprise value divided by its earnings before interest and taxes (EBIT). Let’s break down each of these numbers in the ratio.
A lot of investors tend to migrate to market capitalization to determine a company’s valuation. This metric is measured as the number of shares outstanding multiplied by the share price.
But there’s a better metric to determine the true worth of a company. It’s called enterprise value.
This figure is a measurement of the company’s market capitalization plus its preferred stock plus its debt minus its extra cash.
Here are the four factors we’re looking at to determine enterprise value.
- Market capitalization is measured by shares outstanding times the current stock price
- A company’s preferred stock total is the calculation of all preferred stock on the balance sheet
- A company’s balance-sheet debt is the addition of its long-term and short-term debt
- A company’s excess cash is all of the cash on its balance sheet minus the difference between the following equation: Current liabilities minus current assets
Next, We Look at EBIT
Our next measure is EBIT or “Earnings Before Interest and Taxes.”
Typically, you’ll find people using EBITDA, which adds in Depreciation and Amortization (which are tied to tax policies).
We aren’t using EBITDA because different companies have different tax structures.
By using EBIT, we can compare companies from different industries.
Once we have the EBIT, we’ll do a simple calculation. We can look at Enterprise Value divided by EBIT. This gives us a very important figure.
It tells us the company’s worth divided by its capacity to create profits. So a lower figure implies that the company can generate greater profits in relation to its total worth, making it an attractive target for other organizations.
An EV-to-EBIT ratio under 8 signals that the stock is trading at a very cheap level. So, let’s take a look at a few companies that fit the bill.
Three M&A Watch List Additions
Within TradeSmith Finance, our signals tell investors when to buy, when to wait, and when to avoid a stock. In all three scenarios, however, no signal should deter you from adding a stock to your watch list.
Today, we want to highlight three companies that deserve your attention based on their low EV-to-EBIT multiple. We’re also looking for companies that are fairly valued and have strong balance sheets based on their Piotroski F Score. (The F-Score is a nine-point measurement that tells investors the strength of a company’s balance sheet. The higher the score, the better the company’s underlying fundamentals are.
Let’s take a quick look at these new watch list additions.
- Green Zone: Lousiana-Pacific Corp. (LPX) a leading provider of building products in North America. Founded in 1972 and headquartered in Nashville, Tennessee, the company is operating 25 plants across the U.S., Canada, Chile, and Brazil. Want to know why building supplies continue to go higher? Because this company has successfully been able to pass on higher prices to its customers (large homebuilders.) And as it continues to raise prices, increase stock buybacks, and hike its dividend, the stock continues to trade at very low buyout multiples. The stock’s EV-to-EBIT sits at just 6.32. The stock is in the Green Zone and remains in an uptrend. Wall Street has a consensus price target of $78.40, which represents an upside of roughly 20.3% from last Friday’s closing price. RBC Capital, meanwhile, just rated the stock a Buy and issued a price target of $100. That figure represents a potential upside of 53.5%.
- Yellow Zone: Nautilus (NLS) is a global manufacturer of fitness equipment. Its brands include Bowflex, Schwinn Fitness, and Modern Movement. The company was very successful during the COVID-19 crisis, as more Americans and Canadians turned to at-home gym equipment to stay in shape. With the economy reopening, shares have plunged over the last four months. Shares are off from 52-week highs of $31.38 to roughly $17.50 per share. That said, the company’s financial strength remains very strong, and it has a very low debt-to-equity ratio of just 0.19. With an EV-to-EBIT of just 4.07 and a P/E ratio of 6.52, the stock’s valuation is very low. We’re going to watch this company. If Nautilus starts to get a little momentum and enters our Green Zone, we might want to pick up shares. It could become a very attractive takeover target of a private equity firm or larger competitor that wants to consolidate brands and take on new customers. Even without a deal, Wall Street has a consensus price target of $21 for the stock. NLS is sitting in the Yellow Zone at the moment, it remains in a side trend, and risk remains sky-high based on the VQ of more than 70%. Let this stock decide which direction it wants to go, and act accordingly. If it reenters the Green Zone, it can be an attractive buy. But if it continues to fade, be sure to wait for the right signal before you make a move.
- Red Zone: Lakeland Industries (LAKE) is the final company on the list. It should be on your watch list for the months ahead. One of the biggest success stories of the COVID-19 crisis was Lakeland Industries, a global manufacturer of protective clothing and apparel. Shares climbed from under $11 in January 2020 to as high as $47.95 per share in late February 2021. Since hitting those highs, shares have pulled back sharply. The reopening of the economy has dramatically reduced demand. And forward earnings are not expected to match the sales performance of 2020. However, the company’s boom year helped it clean up its balance sheet and make it an intriguing play as it experiences increased demand from industrial customers that are returning to business. The stock is in the Red Zone at the moment, meaning that investors are advised to let the stock find its bottom and wait for it to reenter the Green Zone. That said, it did recently receive price targets of $35 and $45 per share. Shares are currently trading at an EV-to-EBIT ratio of 3.47. The company may see a dip in earnings with the rebound, but we can continue to watch the stock in the months ahead.
The EV-to-EBIT ratio gives us a strong understanding of a company’s ability to generate earnings compared to the total worth of the company. It also allows us to compare stocks across various industries.
You can add the three stocks above to your watch list or do some additional research. Just be sure to add your watch list within TradeSmith Finance to get a stronger read on buy signals and to bolster your conviction. In the list above, you have a Green Zone buy and two additional stocks to monitor in the months ahead.
I’ll be back tomorrow with additional insight on how to identify winning stocks.