What are we looking for?
My colleague Sean Pugliese and I are following up on our study from last week where we examined free cash flow (FCF). Today we are looking at how FCF relates to the enterprise value, and how we use that in our Safety and Value Portfolio here at Wickham.
We started with TSX-listed companies with more than $1-billion in market capitalization.
We then looked at enterprise value (EV), a figure that can be thought of as roughly equivalent to what a potential buyer would have to ante up to acquire a company, assuming no premium is paid. It's a useful figure because it takes into account both a company's debt and cash.
You calculate EV by taking the market value of a target company's shares and its debt (because a potential buyer would have to assume the debt). You then subtract whatever cash and cash equivalents the target company has on hand, since a potential buyer would acquire that cash in a takeover and could use it to offset, in part, the company's debt.
We then compare EV to the company's cash flow.
As we discussed last week, free cash flow is useful in gauging a company's cash flow beyond what is necessary to grow the company at the current rate. A firm must make capital expenditures to continue to exist, and FCF considers these expenditures.
Putting these two metrics together, the enterprise value and the free cash flow, helps investors figure out whether a company is undervalued. We have sorted our companies based on the FCF/EV over 7.5 per cent, and we are looking for a high number.
The accompanying table also lists the forward price-earnings ratio (P/E) and the expected dividend yield. Both are both based on analysts' consensus opinion over the next 12 months.
What did we find?
The construction industry is represented, with Stantec Inc. and Genivar. Three of the top seven positions are insurance companies: Industrial Alliance Insurance and Financial Services Inc., Great-West Life Assurance Co. and Fairfax Financial Holdings Ltd. (Great-West's parent Power Corp., and another of its subsidiaries, Power Financial, are also among the top seven). Canadian Oil Sands Ltd. is the only oil producer that made the list. The best return, and the second best FCF/EV, is WestJet Airlines Ltd. The total return over the past 12 months for this equal-weighted list of companies is 21.9 per cent.
At Wickham, we use the FCF/EV as a key metric for our proprietary Safety and Value Portfolio. While we are big believers in this ratio, we use additional indicators to fine-tune our equity selections, and so should you.