By David Sterman
In recent years, investors have been steadily pouring billions into exchange-traded funds. The appeal of investing in an industry or thematic style is a simpler approach than stock-picking for many investors.
Yet there are still many investors looking for the most appealing stocks in any given sector. But finding the right stock can be tricky if they all seem to be similarly valued or all are poised to profit from the same trend.
I was thinking about this topic recently as I checked in with the nation's leading auto suppliers. Four months ago, I noted that all of the major companies in this industry were capable of robust share buybacks, thanks to their prodigious cash flow.
It's a theme that has surely resonated with other investor as well, as each of these stocks has since outperformed the S&P 500.
Thanks to ongoing gains, these auto parts suppliers don't look quite as cheap as they once did, with all sporting double-digit price-to-earnings (P/E) multiples. But if you own several of them and would prefer to hang on to only one stock in an industry, there's a way to identify the true value. And it is a more accurate gauge than the use of a simple P/E ratio. It involves a bit of leg work, but is worth the trouble. Better still, it can be applied to almost industry -- not just auto parts suppliers.
What's A Dollar Of Sales Worth?
Make no mistake, a dollar of sales generated by Microsoft (NASDAQ:MSFT) is worth much more than a dollar of sales generated by auto parts suppliers (or any other manufacturing firm). Fully 34 cents out of every sales dollar ends up as operating profit for Microsoft, which makes it one of the highest profit margin generators in the world.
In contrast, let's look at the three-year average operating profit margin for auto parts suppliers.
Clearly, the profit margins in various car components tend to vary, whether you are talking about seats, dashboard, airbags, bumpers, etc. TRW (NYSE:TRW) is clearly able to generate premium pricing for its safety systems that are being used in more high-end cars and trucks. BorgWarner (NYSE:BWA) is now benefiting from its heavy past investments in state-of-the-art transmissions.
As these two firms are clearly the most profitable, each dollar of sales should be perceived as more valuable by investors (since more of that dollar flows to the bottom line). Let's look at the enterprise value, in relation to 2012 sales, for each of these firms to see if that's true.
For the most part, these stocks sport enterprise-value-to-sales (EV/sales) ratios that seem to reflect their profit margin profiles. With 10% operating margins, three times higher than industry laggard Dana Holdings, Borg-Warner's EV/sales ratio is less than twice as high, which suggests its stock is relatively undervalued.
This kind of analysis is most helpful when companies have similar margin profiles or EV/sales ratios. Note that Magna International's (NYSE:MGA) EV/sales ratio is just above the ratio sported by Dana Holdings, yet Magna's operating margins are 67% higher. In this instance, Magna is clearly the better buy. And if you own both stocks, each of which has gained roughly 18% in the past four months, then Dana is the better sell candidate.
You can also use these metrics in paired trade scenarios, by going long the most undervalued -- relative to its operating margin structure -- while shorting the most overvalued one.
Risks to Consider: It's crucial to track ongoing changes in profit margins, as they may be a sign that an industry leader is losing its pricing advantage or that an industry laggard is getting its act together.
You can apply this logic to almost any industry, from medical-device makers and banking stocks to software providers. The apples-to-apples comparisons of financial metrics for companies operating in the same industry can tell you a lot more about valuation than just the P/E ratio.