The venerable price/earnings ratio has long been an integral building block for reasoned stock valuation analysis. This fundamental is recognized as the primary benchmark when comparing a stock versus the "market" or its industry peers. Current or historical P/E ratios can be highly instructive when attempting to discern over or undervalued stocks.
But sometimes it just doesn't work.
In this article, we will explore three case studies where the P/E multiple could mislead an investor. In each example, a different ratio would provide more accurate valuation information and a more-informed investment decision.
Telecommunications Sector Stocks: Case Study for AT&T
First up is AT&T (NYSE:T). Here are some headline numbers for this telco giant:
- Recent Price: $35.43
- Price / Earnings as Reported: 25x
- Price / Operating Earnings: 15x
- EPS growth rate, past five years: -8.4%
- Dividend Yield: 5.1%
A 25x multiple on a slow-growing telecom stock would appear to put AT&T in the dog house. Indeed, this behemoth has shown no appreciable earnings growth over the past five years. A P/E based upon operating earnings (versus as-reported GAAP) lowers the multiple to a 15 handle. Applying general market convention, a 15 P/E may be appropriate for an average large-cap stock, sporting a sustained annual EPS growth rate of 5 to 15 percent. Therefore, even 15x still seems too pricey for T shares. Its EPS growth rate has been flat for 10 years.
Is AT&T overvalued?
The short answer is no. When valuing these shares, price/earnings is not the proper valuation metric to use. For most Telecom sector stocks, the Price / Cash Flow multiple is far more instructive. Let's examine the stock through that lens:
- Operating Cash Flow ((NYSE:TTM)): $37.4 billion
- Operating Cash Flow per share: $7.08
- Price/Cash Flow: 5x
Generally, a P/CF ratio less than 10x marks a value stock. AT&T is half that. Focusing upon the Diversified Telecommunications Service industry, the average Price/Cash Flow multiple is 7x. T stock is valued well below the overall industry benchmark, too.
Furthermore, despite declining earnings, operating cash flows have been rising. AT&T stock is a demonstrable example how reviewing P/E without checking alternate valuation metrics could drive an investor away from an otherwise reasonably-priced security.
Versus U.S. Telecommunication peers, AT&T appears well-positioned. Verizon Communications (NYSE:VZ) expresses a similar cash flow multiple, while rival T-Mobile (NASDAQ:TMUS) is spot-on the overall industry average.
Here is a 10-year F.U.N. Graph (Fundamental Underlying Numbers), provided via F.A.S.T. graph creator and fellow S.A. contributor Chuck Carnevale, that summarizes the historic relationship between AT&T operating earnings and operating cash flow:
This is a clear case where cash flow per share trumps earnings per share. Stocks within the Telecommunications sector should always be checked for operating cash flow as part of an investor's due diligence process. Cash is King.
Cyclical Stocks: Case Study for International Paper
Next, let's look at International Paper (NYSE:IP), the largest paper and packaging corporation in the world. It's one of my favorite Materials sector equities. Here's the headline numbers:
- Recent Price: $45.53
- Price / Earnings as Reported: 18x
- Price / Operating Earnings: 15x
- EPS growth rate, past five years: -9.5%
- Dividend Yield: 3.1%
How can a stock with negative 5-year average annualized GAAP earnings and a current ttm 18x multiple be anything other than overvalued? If operating earnings are substituted for GAAP earnings, the P/E drops by a few multiple points. Fifteen times trailing EPS is the rough average for the universe of large-caps, not an earnings laggard.
Should International Paper be scratched off a "buy" list immediately?
No. Materials sector companies are cyclical stocks. Such names are typified by vacillating earnings contingent upon the economic business cycle, and heavy capital expenditures. The Price/Earnings ratio can be skewed by down-cycle heavy capex, thereby reducing earnings results via outsized depreciation and amortization expenses.
Examining share price as a function of cash flow offers a better line-of-sight. However, a superior metric is often Price/Free Cash Flow. P/FCF measures not only the ability of the enterprise to generate operating cash, but measure the net cash position after subtracting routine capital expenditures.
Here's what these results look like:
- Operating Cash Flow: $3.0 billion
- Operating Cash Flow per share: $6.77
- Price / Cash Flow: 7x
- Free Cash Flow: $1.8 billion
- Free Cash Flow per share: $4.02
- Price / Free Cash Flow: 11x
A Price/OCF ratio of 7x certainly appears strong enough. Remember, anything less than 10x generally signals a reasonable value stock. However, a bit more research indicates that Paper and Forest industry stocks average a 6x Price / Cash Flow multiple. Therefore, International Paper is simply on-par versus peers.
The P/Free Cash Flow metric shines a bit more light on the situation.
International Paper sports an 11x P/FCF multiple. This means that International Paper generates more cash after routine capital expenditures than operating earnings.
Going one step further, major Paper and Packaging competitors Rock Tenn (RKT), Packaging Corporation of America (NYSE:PKG) and MeadWestvaco (MWV) have trailing twelve-month Price/FCF ratios of 12, 11 and negative free cash, respectively. When viewed together on a table, the numbers tell a story; and a degree of separation begins to open up for International Paper.
Continued due diligence notes the company is still digesting its 2012 Temple-Inland acquisition, too. Management has promised meaningful incremental cost efficiency improvements in 2014 and beyond.
The table suggests that International Paper is not overvalued at all. Combining the TIN acquisition narrative, it may very well be undervalued. Cash multiples are in-line or better with smaller peers, and are tracked to improve further as post-merger cost efficiencies are wrung out. International Paper also has a better dividend yield.
Please find below another 10-year F.U.N. graph comparing IP's historical earnings, cash flow, and free cash flow per share:
Pipeline MLPs: Case Study for Energy Transfer Partners
Lastly, we will review Energy Transfer Partners (NYSE:ETP). It's a large, integrated hydrocarbon pipeline MLP. Here are the headline numbers:
- Recent Price: $53.13
- Price / Earnings as Reported: 27x
- Price / Operating Earnings: 25x
- EPS growth rate, past five years: 5.6%
- Distribution Yield: 6.8%
The earnings multiple sure looks pretty high for a high-yield, low-growth MLP. A 27x ratio should raise the eyebrows of any value investor, and perhaps scare away all but the most aggressive growth investors.
What's going on here?
Generally, Master Limited Partners are poor candidates for Price/Earnings comparisons. The metric is worth a little more than nothing. MLP entity structure and business operations require alternative valuation measurements.
Certainly, a Price/Cash Flow check is in order, given the large distribution payout.
In the case of Energy Transfer Partners, the ttm P/CF is 10x; a reasonable starting point. Over the past four quarters, ETP has generated $5.39 operating cash per unit. Therefore, at least we know that the unit holder distribution is well-covered by that metric. Plus we can surmise that most stocks with a sustainable price-to-cash flow ratio of 10 times or less represents decent value.
However, pipeline MLPs have numerous other cash and accounting factors that complicate matters. Free Cash Flow analysis may be helpful, but I prefer to use several other valuation checks when evaluating Master Limited Partnerships.
Let's run them down:
Interest Coverage Ratio. The formula for ICR is EBIT (Earnings Before Interest and Taxes) divided by Interest Expense. Pipeline MLPs carry a lot of debt, so this financial measure tests how comfortably the business can service its borrowing expenses. For a MLP, I believe a ratio of 1.5x or more is adequate. Energy Transfer Partners currently has an interest coverage ratio of 3.3x. Check.
Leverage Ratios. Different MLPs choose to measure financial leverage by using various metrics. Debt-to-Equity or Debt-to-Capital ratios may be utilized. For the case of Energy Transfer Partners, management uses a Debt-to-EBITDA ratio. The stated bogey range is 4.0x to 4.25x. ETP has a 9-month annualized D2EBITDA ratio of 4.1x: on target. Check.
Distributable Cash Flow Coverage Ratio. DCF or similar derivatives are non-GAAP measures that may vary by MLP. While it may be called different things, and may be calculated somewhat differently, the bottom-line is the same: management is gauging whether or not the company generates enough hard currency after cash and capex expenses to cover the unit holder cash distributions.
Energy Transfer Partners' management targets DCF > 1.05x. Current financial statements offer a most recent quarter 1.14x ratio, and a 1.02x marker for the past 9 months. Check.
Finally, there's one more valuation guideline I employ when comparing pipeline MLPs:
Distribution Yield Above T-Notes. Assuming a MLP can cover its distributions, I like to compare the current cash distribution yield with the current 10-year U.S. Treasury bond rate plus 300 basis points. I consider the T10+300 yield an approximate fair-value marker.
For many MLP investors, the income stream is paramount. Therefore, it's reasonable to check the cash distribution yield versus an alternative yield from "no risk" Treasury securities. My view is that 300 bps begins to adequately compensate the investor for the extra risk to carry MLP investments versus 10-year Treasuries. Checking the FRB website, the 10-year note closed Friday at 2.7 percent.
Therefore, I see MLPs with a yield greater than 5.7 percent to lean undervalued, and those that fall below that mark to be at fair value or overvalued.
I compiled the following table comparing eight of the most popular pipeline MLPs: Energy Transfer Partners, Enterprise Products (NYSE:EPD), Kinder Morgan Energy (NYSE:KMP), Williams Partners (NYSE:WPZ), Regency Energy (NYSE:RGP), Plains All American (NYSE:PAA), Magellan Midstream (NYSE:MMP), and Oneok Partners (NYSE:OKS) using this barometer.
By this measure, four appear undervalued and four appear to trade at a premium:
As with any valuation measure, this table is not intended to be an "end all" argument. It is a tool for the prudent investor to begin further investigation as to whether or not adequate income is being received to compensate for the investment risk associated with the corresponding MLP business.
The Price/Earnings ratio is one of the most widely-used valuation metrics. Nonetheless, investors must be aware that it can provide skewed or even misleading information; particularly for stocks in certain sectors or industries.
Telecommunication, cyclical, and Master Limited Partnership stocks are just three segments of the market where P/E multiples often do not provide the investor an adequate gauge of underlying security valuation.
Other multiples of cash flow or its derivatives may offer considerably better data points.
Please do your own careful due diligence before making any investment decision. The information contained in this article is for illustrative and educational purposes only. Good luck with all your 2013 investments.
Disclosure: I am long T, IP, ETP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.