Tom Shohfi's  Instablog

In a class early last academic year, I drew a quick diagram for students to summarize valuation between the balance sheet and income/cash flow statements: simply three blocks making up a horizontal bar. The first block being net tangible equity, the second intangibles that added value to the company and the third representing the future cash flows that the company was likely to produce according to reasonably constructed financial models. As we move from the left to the right, things change. Net tangible book equity is on the balance sheet right now and can, assuming financial statements are represented fairly, be valued rather easily. Intangibles are more difficult to measure as some, such as goodwill, are effectively worthless while others are intertwined with future cash flows and can not be liquidated easily. Certainty increases moving from right to left and upside for investors changes in the opposite direction. Future negative cash flows would eat away at tangible assets (cash hemorrhaging or "right folding" effect) and would therefore easily explain why many unprofitable public companies are priced at discounts to tangible equity.

Free cash flow (FCF) yield can is an often overlooked financial metric in equity valuation. The cash generated from operations after capital expenditures is what effectively belongs to shareholders in the form of dividends or retained earnings. That’s why many fundamental value analysts use FCF yield as an important gauge of the ongoing financial health of a company. If cash is king, then free cash flow is the path to royalty. Here are ten stocks with high double digit last twelve months free cash flow yields (actually greater than 12.5% FCF yield when considering an anticipated drop of no less than 20% during a weaker 2009) with price to tangible book values and trailing P/E ratios less than or equal to the average values of the Russell 2000 small cap index.

American Physicians Service Group (AMPH) – To start off the list, let’s head to that state where everything is bigger: Texas. AMPH is a medical malpractice insurer based out of Austin and provides a number of other financial services outside of its core business. Over the past two years, the stock has handily outperformed the S&P 500 and Russell 2000 as well as the overall healthcare and insurance sectors.Since correlation with the XLV (0.48) and XLF (0.39) have been low over the past twelve months, AMPH may represent a unique position to minimize actual sector exposure in a portfolio. The company’s investment portfolio has been managed extremely well. COO Tim LaFrey mentioned their avoidance of subprime and auction rates in last November’s conference call. FCF may not necessarily be the best metric to measure the performance a financial/insurance company, but a price to tangible book ratio below its peer group and very conservative leverage (total assets/liabilities are less than two) make AMPH an ideal name to weather these uncertain times in healthcare and financial services.

Last November, my first Seeking Alpha contribution featured five profitable small capitalization stocks priced at significant discounts to tangible book value. Since that time, the Russell 2000 (^RUT) has fallen about 13%. However, all five of those stocks have outperformed the index and two, Chinese dietary supplement manufacturer Tiens Biotech Group (TBV) and zinc producer Horsehead Holdings (ZINC), have seen very high returns over the past five months. I once heard a director of equity research at a large buy side firm say that an analyst doesn’t necessarily have to be right on stock calls more than 50% of the time, but when he/she makes a right call, it better be very right. TBV no longer fits the criteria of trading at a fraction of tangible book value. However, since ZINC is still trading at a slight discount and is a reasonably good dollar weakness play, I’m still holding on to it for now but am examining other opportunities that may represent better present values.