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By Brian Nelson, CFA

Executive Summary: We break down the components of a price-to-earnings multiple and show how stocks with high price-to-earnings multiples can be undervalued -- seven such ideas we highlight for investors in this article.

To get things started, we’d like to offer a quote from the Oracle of Omaha about how growth is a critical component of assessing intrinsic value.

But how, you will ask, does one decide what [stocks are] "attractive"? Most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth,"...We view that as fuzzy thinking...Growth is always a component of value [and] the very term "value investing" is redundant.

-- Warren Buffett, Berkshire Hathaway annual report, 1993

What Buffett is talking about above is the price-to-earnings (PE) ratio and, more importantly, how the valuation process should determine what that price-to-earnings ratio should be on a stock. Instead, some investors fall into the trap of applying an arbitrary (historical or peer median) price-to-earnings ratio to earnings in order to determine the “value” of a stock – a process we view as a dangerous shortcut.

As followers of Valuentum know, we use a discounted cash-flow valuation process to uncover the intrinsic worth of every company in our coverage universe (our template for the individual investor can be found here). Many investors may ask: Why do you use a free cash flow model when stock prices are driven by earnings? Well, to a very large extent, earnings and cash flows are correlated over the long run. And we would posit that stock prices are driven by cash flow, of which earnings is a key component. So, when we’re talking about cash flows, it is inclusive of earnings.

With that out of the way, let’s briefly discuss the major differences between earnings and cash flow. The variations between the two not only arise in working capital changes over time (and their influence on a firm’s cash flow from operations), but also in the timing of the cost of replacing those assets that generate earnings (capital expenditures versus depreciation). Plus, varying levels of interest rates paid on debt loads can also muddy the waters on earnings – not to mention the various levels of ways to account for rent expense (whether to capitalize such assets or to allow the expense to flow through the operating line). So there are some major differences between assessing a company’s value based on earnings versus based on using a discounted cash-flow model.

But we would opine that using a free cash flow model is superior to most other valuation processes out there. Though there are many, many ways of looking at a stock—in fact, varying perspectives remain core to our process--using a free cash flow process is perhaps the only way investors can truly arrive at the “correct” intrinsic price-to-earnings multiple to place on any given stock. For example, have you ever wondered why capital light companies garner higher earnings multiples than capital-intensive companies [think Ford (NYSE:F), General Motors (NYSE:GM)]? Well, capital-intensive companies have to re-invest a significant amount of earnings back into their businesses, thereby reducing cash flow and the multiple investors are willing to pay for that earnings stream. Simply put, not all earnings streams are created equal – even given equivalent future expected growth trajectories.

Okay…on to demystifying the price-to-earnings ratio

At this point, we hope that we have convinced you that there is much more to valuing a stock than placing an arbitrary multiple on next year’s earnings. We can only encourage investors not to take such short cuts. Even if that multiple is based on historical ranges or is comparable to peers, investors fall short of capturing the uniqueness of a company’s future cash flow stream, which considers all of the qualitative factors of a company -- from a competitive assessment to the company's efficiency initiatives and beyond.

Okay, let’s get to the point: here is our definition of the price-to-earnings ratio. You’ll notice that it is forward-looking and considers many more components than just the future growth trajectory of earnings:

Current Price to Earnings Ratio = {[(Sum of Discounted Future Enterprise Free Cash Flows – Total Debt – Preferred Stock + Total Cash)/Shares Outstanding]/ Current Earnings Per Share}

And below, we show how a few qualitative factors influence the price-to-earnings multiple and whether they are positively or negatively correlated to it.

Revenue Growth: Impacts Future Enterprise Cash Flows (Mostly Positive)

Operating Earnings Growth: Impacts Future Enterprise Cash Flows (Positive)

Taxes: Impacts After-tax Earnings, Cost of Debt (Mostly Negative)

Capital Expenditures: Impacts Future Enterprise Cash Flows (Negative)

Return on Invested Capital (ROIC): Function of Operating Earnings and Net New Investment, Capital Expenditures (Positive)

Risk-free Rate: Impacts WACC (Negative)

Discount Rate (WACC): Impacts Present Value of Enterprise Cash Flows (Negative)

Total Debt: Impacts Enterprise Value and Discount Rate (Mostly Negative)

Preferred Stock: Impacts Enterprise Value and Discount Rate (Mostly Negative)

Total Cash: Impacts Enterprise Value (Positive)

Shares Outstanding: Changes in Shares Outstanding (Neutral, assuming reinvestments' ROIC equal the firm’s WACC)

Upon further examination of the definition of the price-to-earnings ratio above, you’ll see that it is just a compressed discounted cash-flow model. The takeway here is that without using a discounted cash-flow model, the price-to-earnings ratio to be applied to a company's earnings cannot really be solved. And by extension, when investors throw an arbitrary price-to-earnings multiple on a company’s earnings, they are essentially making estimates for all of the drivers behind a discounted cash-flow model (and sometimes hastily). The price-to-earnings ratio requires as much thought--and perhaps even more thought--than earnings, itself. That's why we perform significant DCF analysis.

We do the homework to estimate what a company is truly worth – we don’t use shortcuts by throwing arbitrary price-to-earnings multiples on stocks based on what a company has done in the rear-view mirror or what a peer has accomplished. We focus on forward-looking valuation analysis that considers the plethora of qualitative factors embedded in the definition of the price-to-earnings ratio above (and more). And it continues to pay off. We called the top on Netflix (NASDAQ:NFLX) and the bankruptcy of AMR Corp (AMR), the parent of American Airlines, and even a double in EDAC Tech (NASDAQ:EDAC). In fact, the return in the portfolio of our Best Ideas Newsletter continues to trump that of the market by a significant margin.

Seven Undervalued Stocks with Above Average Earnings Multiples

All that said, we reveal seven stocks that represent one of the key takeaways of this article: stocks can be undervalued even with above-average earnings multiples (we set 15x as the commonly accepted average multiple for the screen below). Here are seven stocks that are undervalued on our DCF process and have above-average earnings multiples.

(Click chart to expand)

If you've enjoyed reading this article, please be sure to recommend it to others.

Source: What Is The PE Anyway...7 Unusually Undervalued Stocks