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Because firm value is derived from firm profitability, any stock analysis should consider the sources of a company’s profitability.

For that reason, we ran a DuPont analysis of ROE for stocks that appear to be undervalued relative to earnings growth (with PEG < 1) and free cash flow (with P/FCF < 10). We found 8 companies that passed all requirements for positive results.



We broke the ROE equation into three parts:

ROE
= (Net Profit/Equity)
= (Net profit/Sales)*(Sales/Assets)*(Assets/Equity)
= (Net Profit margin)*(Asset turnover)*(Leverage ratio)

All of the stocks mentioned below have seen rising ROE values for the recent quarter, year-over-year. Then we wanted to analyze the sources of these returns, so we narrowed down the original universe to only focus on companies with the following characteristics:

  • Decreasing leverage, i.e. decreasing Asset/Equity ratio
  • Improving asset use efficiency (i.e. declining Sales/Assets ratio) and improving net profit margin (i.e. declining Net Income/Sales ratio)

Companies passing all requirements are thus experiencing increasing profits due to operations and not to increased use of leverage.

Do you think these stocks are attractively priced? Use this list as a starting-off point for your own analysis.

List sorted by increase in quarterly ROE year-over-year.

Mercer International Inc. (NASDAQ:MERC): Paper & Paper Products Industry. Market cap of $560.93M. PEG at 0.79. P/FCF at 3.21. Return on Equity increased from -6.11% to 10.55%. When analyzing the sources of return, Net Profit Margin increased from -4.19% to 12.96%. Sales/Assets increased from 0.1612 to 0.1856, while Assets/Equity decreased from 9.0566 to 4.3858 (comparing 3 mo. ending 3/31/10 vs. 3 mo. ending 3/31/11). This is a risky stock that is significantly more volatile than the overall market (beta = 3.3).



Power-One Inc. (NASDAQ:PWER): Diversified Electronics Industry. Market cap of $906.76M. PEG at 0.46. P/FCF at 5.04. Return on Equity increased from 4.44% to 18.03%. When analyzing the sources of return, Net Profit Margin increased from 4.40% to 14.85%. Sales/Assets increased from 0.3836 to 0.4807, while Assets/Equity decreased from 2.6313 to 2.5256 (comparing 3 mo. ending 1/3/10 vs. 3 mo. ending 1/2/11). The stock is a short squeeze candidate, with a short float at 31.91% (equivalent to 7.16 days of average volume).



Constellation Brands Inc. (NYSE:STZ): Wineries & Distillers Industry. Market cap of $4.84B. PEG at 0.87. P/FCF at 9.12. Return on Equity increased from -1.98% to 10.96%. When analyzing the sources of return, Net Profit Margin increased from -7.20% to 39.12%. Sales/Assets increased from 0.0876 to 0.0998, while Assets/Equity decreased from 3.1418 to 2.8087 (comparing 3 mo. ending 2/28/10 vs. 3 mo. ending 2/28/11). The stock has gained 27.58% over the last year.



Tesoro Corporation (NYSE:TSO): Oil & Gas Refining & Marketing Industry. Market cap of $3.37B. PEG at 0.28. P/FCF at 9.06. Return on Equity increased from -5.27% to 3.21%. When analyzing the sources of return, Net Profit Margin increased from -3.36% to 1.64%. Sales/Assets increased from 0.5557 to 0.6974, while Assets/Equity decreased from 2.8191 to 2.8111 (comparing 3 mo. ending 3/31/10 vs. 3 mo. ending 3/31/11).

ASM International NV (NASDAQ:ASMI): Semiconductor Equipment & Materials Industry. Market cap of $2.37B. PEG at 0.54. P/FCF at 8.23. Return on Equity increased from 1.56% to 8.18%. When analyzing the sources of return, Net Profit Margin increased from 1.90% to 9.27%. Sales/Assets increased from 0.2416 to 0.2774, while Assets/Equity decreased from 3.3937 to 3.1814 (comparing 3 mo. ending 3/31/10 vs. 3 mo. ending 3/31/11). This is a risky stock that is significantly more volatile than the overall market (beta = 2.35). The stock has had a good month, gaining 12.83%.

Smithfield Foods Inc. (NYSE:SFD): Meat Products Industry. Market cap of $3.41B. PEG at 0.91. P/FCF at 9.81. Return on Equity increased from 1.29% to 6.24%. When analyzing the sources of return, Net Profit Margin increased from 1.29% to 6.36%. Sales/Assets increased from 0.3744 to 0.4138, while Assets/Equity decreased from 2.6583 to 2.3698 (comparing 13 weeks ending 1/31/10 vs. 13 weeks ending 1/30/11). It's been a rough couple of days for the stock, losing 6.16% over the last week.

7. Xerox Corp. (NYSE:XRX): Business Equipment Industry. Market cap of $14.31B. PEG at 0.97. P/FCF at 9.49. Return on Equity increased from -0.36% to 2.19%. When analyzing the sources of return, Net Profit Margin increased from -0.89% to 5.14%. Sales/Assets increased from 0.1542 to 0.1771, while Assets/Equity decreased from 2.6520 to 2.4000 (comparing 3 mo. ending 3/31/10 vs. 3 mo. ending 3/31/11). The stock has gained 3.65% over the last year.

8. LTX-Credence Corporation (LTXC): Semiconductor Equipment & Materials Industry. Market cap of $430.30M. PEG at 0.6. P/FCF at 6.35. Return on Equity increased from 0.76% to 2.32%. When analyzing the sources of return, Net Profit Margin increased from 1.69% to 8.96%. Sales/Assets increased from 0.1917 to 0.1992, while Assets/Equity decreased from 2.3553 to 1.3012 (comparing 3 mo. ending 1/31/10 vs. 3 mo. ending 1/31/11).

*Accounting data sourced from Google Finance, all other data sourced from Finviz.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: 8 Highly Undervalued Stocks With Strong Sources of Profitability