While valuing an investment is not a rigid science but rather a fluid process, there are certain metrics that valuation anchors itself upon. The price to earnings, or P/E ratio, is the most common. Another is free cash flow in relation to market value. Yet another is return on equity. These three metrics are all derived at least partially from the information presented on the income statement. The income statement metrics should not be relied upon without considering the balance sheet. The principal data point to look for here is debt in relation to assets. As the financial crisis has shown us, even the most profitable business can deteriorate because of an over levered balance sheet.
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Cheap by Any Measure
With markets enjoying a seemingly elevated plateau, a name like Microsoft (Nasdaq:MSFT) stands out for various reasons. The P/E is 10. The company has a market cap of $220 billion and generated over $24 million in operating cash flow in fiscal 2010. The company has a Fort Knox like balance sheet with nearly $50 billion in cash and $12 billion in long term debt. Return on equity is 43% and pays out a 2.5% to boot. Fellow tech titan Cisco (Nasdaq:CSCO) is also a large cap that looks attractive on these valuation metrics. Cisco sports a current P/E of 13, has $25 billion in net cash and sports a return on equity of 17%. Over the past three years, operating cash flow has averaged over $10 billion a year. With an enterprise value of $71 value, Cisco is currently valued at 7 times EV/FCF.
Big is Beautiful
In fact, larger cap stocks seem to possess all the value attributes in today's market. Defense giant Lockheed Martin (NYSE:LMT) currently trades at 9 times current and forward earnings. The company has earned over $2 billion in free cash flow in each of the past three years. The current market cap is $28 billion. Retailing is a very tough and competitive business and usually an area I tend to avoid, but electronics giant retailer Best Buy (NYSE:BBY) is a name worth mentioning. The company is in the midst of an electronics down cycle and earnings are retreating. As a result shares trade hands for $31 a share, valuing the company at less than 9 times next year's earnings. The company has very little net debt and boasts an impressive ROE of 19%. Over the past few years, Best Buy has seen one of its major competitors, Circuit City, disappear. As the largest electronics retailer in the United States, Best Buy may be worth a closer look.
Value should not be a function of size, but rather a relationship between price paid and value received. For most investors, large caps today hold that relationship and, as such, you are getting a decent upside along with protection on the downside as a result of fortress like balance sheets and quality operations. (So you've finally decided to start investing. But what should you put in your portfolio? Find out here. Check out How To Pick A Stock.)
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