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11/9/2011 2:09:38 AM
(Wrtten by Rebecca Lipman. List compiled by Eben Esterhuizen, CFA. LFCF data sourced from Yahoo! Finance, all other data sourced from Finviz.)
Interested in technology companies? For this list we searched the tech sector for companies deemed undervalued by not one, but two analyst strategies: Price to earnings growth ratio and the levered free cash flow to enterprise value ratio.
We began with a universe of technology stocks with market caps over $300M. We narrowed the list down to those undervalued by the levered free cash flow to enterprise value (LFCF/EV) ratio and kept only the names that appear undervalued by over 5%.
Levered Free Cash Flow/Enterprise Value
Levered free cash flow, or the free cash flow available after paying interest on debt, is a helpful way to measure firm value because it is the cash flow available to shareholders. Enterprise value is the sum of the firm’s value from all ownership sources: market cap, outstanding debt, and preferred shares. From this value we subtract cash holdings because, in the event of a takeover, that cash would be used towards the takeover price.
When the ratio of levered free cash flow to enterprise value is high, it may indicate that the price is too low. At the very least, it indicates that the company is producing a lot of cash.
Next, we searched for the tech companies that appear undervalued by the price to earnings growth (PEG) ratio. This is a financial ratio that incorporates the market’s expectations of a company’s future earnings. A stock with a high PEG ratio is considered expensive or overvalued, while a stock with a low PEG ratio is considered cheap or undervalued. We only kept the names with PEG below 1.
Price to Earnings Growth
The P/E ratio is a widely-used tool for valuing a stock. P/E is short for the share price to earnings per share (EPS). The ratio indicates how much investors are paying for a dollar of earnings. P/E = (Share Price)/(EPS)
It is important to remember that share prices take into account expected future earnings growth. So investors might be willing to pay a high price today if they expect a company’s earnings to grow significantly in the future. This makes comparing P/E ratios complicated — some industries have high earnings growth trends, which inflates a company’s P/E relative to companies in other industries.
This is where PEG ratios become handy. PEG is short for the Price/Earnings to Growth ratio. The PEG ratio takes the P/E ratio one step further by including a calculation for annual earnings (EPS) growth. PEG = (P/E)/(Annual EPS Growth). Therefore, the higher the earnings growth the lower the PEG ratio. So a company that looks overvalued because of its relatively high P/E might look like a better investment if you take into account its high earnings growth.
Without further adieu, here is our final list of technology companies that appear most undervalued when using the two investment techniques described above.
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