Software Companies Show High Value Potential

Undervalued Predictable Screener lists top technology stocks

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Sep 29, 2016
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Among companies trading on the New York Stock Exchange and the Nasdaq, software companies generally have been undervalued and predictable. Based on backtesting results, the “Undervalued Cash Flow Screener” bought Intel Corp. (INTC, Financial) and Oracle Corp. (ORCL, Financial) in January 2013. While these companies presented high value potential during the past three years, other software companies offer better investment opportunities in 2016, including Apple Inc. (AAPL, Financial) and F5 Networks Inc. (FFIV, Financial). The latter made both the Undervalued Predictable Screener and the Buffett-Munger Screener as of Sept. 29.

Cash flow valuations determine undervalued companies

Previous articles discussed several types of valuation ratios, including basic valuation ratios, enterprise value ratios and “asset efficiency / earnings quality” ratios. This article will focus on the cash flow valuations: price to free cash flow, price to operating cash flow and price to discounted cash flow.

Among the three ratios, the price to discounted cash flow (DCF) offers a comprehensive valuation based on the company’s balance sheet values, earnings per share and projected earnings growth. As discussed in a research article, the DCF model computes the intrinsic value based on four separate factors: the book value of shareholder’s equity, the earnings / free cash flow, the discount rate and the terminal value.

We can calculate the intrinsic value based on earnings or free cash flow. While the FCF-based intrinsic value is most commonly used in business finance courses, GuruFocus computes the fair value based on the company’s earnings per share without nonrecurring items. As mentioned in the research study, most value investors suggest that earnings have stronger correlations with the stock price than does free cash flow.

The distribution of average P/FCF ratios across industries has the highest mean, median and standard deviation among the three cash flow valuation distributions. On the other hand, the distribution of average price-to-intrinsic-value ratios has the lowest standard deviation.

Cash Flow Ratio P/FCF P/OCF P/DCF per share P/DCFE
Mean 31.91 15.37 1.80 2.14
Standard Error 3.03 0.81 0.13 0.17
Median 22.50 13.45 1.61 1.64
Standard Deviation 32.05 8.53 1.34 1.82
Sample Variance 1027.23 72.79 1.81 3.30
Skewness 3.48 2.18 4.79 3.78
Range 221.50 52.72 11.53 13.32
Minimum 3.69 2.73 0.42 0.46
Maximum 225.18 55.45 11.95 13.78
Count 112.00 112.00 112.00 112.00

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Intel and Oracle make way for other undervalued tech companies

The Undervalued Cash Flow Screener lists the companies that meet the following criteria:

  • The company’s financial strength rank is at least 6, and has at least a four-star predictability rank.
  • The company’s P/FCF and P/OCF ratios are both less than 15.
  • The company’s earnings-based P/DCF is less than 1.

Excluding over-the-counter stocks, just 17 U.S. companies made the Undervalued Cash Flow Screener as of Sept. 29. The list includes Apple, F5 Networks and Syntel Inc. (SYNT).

As implied by the backtesting results, Intel and Oracle had a predictability rank of at least 4.5 stars in 2013. Despite having a slightly higher P/FCF, Intel’s earnings-based P/DCF was 0.37. The following table summarizes the financial information about the two stocks in 2013.

Symbol Company Financial Strength Predict P/FCF P/OCF DCF (Earnings Based) Value DCF (Earnings Based) P/Value Num. of Years of Profitability Over the Past 10 Years
INTC Intel Corp 8 ★★★★½ 13.41 5.56 55.26 0.37 10
ORCL Oracle Corp 7 ★★★★★ 13.02 12.34 51.93 0.64 10

Likely due to high profitability and predictability, the stock price of both companies increased during 2013. However, Intel’s price to free-cash flow climbed above 15 in April 2014, reaching a five-year high by the end of 2015. Additionally, Intel’s earnings-based P/DCF increased to 0.84 and its predictability rank dropped to four stars.

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Intel currently has a one-star predictability rank on watch. Although it has expanding operating margins, Intel has five medium warning signs, including historically high price-to-sales ratios, per-share revenue growth slowdown and issuance of new debt.

Despite having a higher predictability rank, Oracle has a slightly weaker financial outlook than does Intel. The company’s interest coverage underperforms 81% of global infrastructure companies, its Piotroski F-score is an acceptable 5 out of 9, and its Altman Z-score barely breaks the safe-zone threshold. Based on these financial metrics, Oracle has a modest financial strength rank of 5.

On the other hand, Apple and F5 Networks have strong financial outlooks. Apple, one of several stocks that the test portfolio held for multiple years, maintained its 4.5-star predictability rank since 2013 albeit slightly declining financial strength. Even though the company issued new debt and traded near a 52-week high, Apple still has operating margins, returns on equity and three-year revenue growth in the top 10% of global consumer electronics companies. The California-based mobile media company currently has a profitability rank of 8, suggesting that it has a higher profitability and may stay that way in the short term.

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Among the tech stocks discussed, F5 Networks has the highest financial strength and profitability. The Washington-based application software company has no debt, strong F and Z scores, and a return on equity near a 10-year high. Additionally, F5’s return on invested capital significantly outperforms its WACC, suggesting strong value potential in the short term.

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See also

The GuruFocus Fair Value Calculator allows you to calculate the intrinsic value of a company based on its EPS (w/o NRI), the initial and terminal growth rates, the years of terminal growth and the discount rate. As discussed above, the DCF model only works for companies with a high predictability rank, usually greater than three stars. The following YouTube tutorial further details the DCF Calculator.

Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) prefer companies that have high business predictability and are undervalued based on the PPEG ratio. Premium members have access to all the value screeners, including the popular Buffett-Munger Screener. Additionally, the premium membership includes access to the monthly Buffett-Munger Newsletter, the Manual of Stocks for companies trading on the Standard & Poor’s 500 index, real-time guru picks and insider trends. The premium plus membership gives further access, including the Manual of Stocks for all U.S. companies and up to 10-years of backtesting and 20,000 monthly queries in the Excel Add-in and API. Please review the membership benefits and sign up for a free seven-day trial.

Disclosure: The author has no position in any of the stocks mentioned in this article.

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