Numbers can lie -- but they're the best first step in determining whether a stock is a buy. In this series, we use some carefully chosen metrics to size up a stock's true value based on the following clues:
The current price multiples.
The consistency of past earnings and cash flow.
How much growth we can expect.
Let's see what those numbers can tell us about how expensive or cheap Sears Holdings (NAS: SHLD) might be.
The current price multiples
First, we'll look at most investors' favorite metric: the P/E ratio. It divides the company's share price by its earnings per share -- the lower, the better.
Then, we'll take things up a notch with a more advanced metric: enterprise value to unlevered free cash flow. This divides the company's enterprise value (basically, its market cap plus its debt, minus its cash) by its unlevered free cash flow (its free cash flow, adding back the interest payments on its debt). Like the P/E, the lower this number is, the better.
Analysts argue about which is more important -- earnings or cash flow. Who cares? A good buy ideally has low multiples on both.
Sears has negative P/E and EV/FCF ratios over the trailing 12 months. If we stretch and compare current valuations to the five-year averages for earnings and free cash flow, Sears has a P/E ratio of 22.7 and a five-year EV/FCF ratio of 14.9.
A positive one-year ratio under 10 for both metrics is ideal (at least in my opinion). For a five-year metric, under 20 is ideal.
Sears has a mixed performance in hitting the ideal targets, but let's see how it compares against some competitors and industry mates.
J.C. Penney (NYS: JCP)
Target (NYS: TGT)
Wal-Mart (NYS: WMT)
Source: S&P Capital IQ; NM = not meaningful due to losses.
Numerically, we've seen how Sears's valuation rates on both an absolute and relative basis. Next, let's examine...
The consistency of past earnings and cash flow
An ideal company will be consistently strong in its earnings and cash flow generation.
In the past five years, Sears's net income margin has ranged from -0.8% to 2.4%. In that same time frame, unlevered free cash flow margin has ranged from -0.6% to 3.8%.
How do those figures compare with those of the company's peers? See for yourself:
Source: S&P Capital IQ; margin ranges are combined.
Additionally, over the last five years, Sears has tallied up three years of positive earnings and four years of positive free cash flow.
Next, let's figure out...
How much growth we can expect
Analysts tend to comically overstate their five-year growth estimates. If you accept them at face value, you willoverpay for stocks. But while you should definitely take the analysts' prognostications with a grain of salt, they can still provide a useful starting point when compared to similar numbers from a company's closest rivals.
Let's start by seeing what this company's done over the past five years. Due to losses, the trailing growth rate for Sears isn't meaningful. Here's how its peers performed:
Source: S&P Capital IQ; EPS growth shown.
And here's how it measures up with regard to the growth analysts expect over the next five years: 75% for Sears, 15% for JC Penney, 11% for Target, and 10% for Wal-Mart. If you're excited about Sears' crazy-high growth estimate, remember that Sears is currently unprofitable, so the estimate is most likely off a very low adjusted base.
The bottom line
The pile of numbers we've plowed through has shown us the price multiples shares of Sears are trading at, the volatility of its operational performance, and what kind of growth profile it has -- both on an absolute and a relative basis.
The more consistent a company's performance has been and the more growth we can expect, the more we should be willing to pay. We've gone well beyond looking at a negative P/E ratio, and we see that Sears' five-year price multiples are better than its one-year multiples. However, it's not encouraging that Sears has slipped into unprofitability both on an earnings and free cash flow basis. My fellow Fool Sean Williams isn't excited about its prospects, and it's only rated one star (out of five) by our CAPS community.
However, if you find Sears' numbers or story compelling, don't stop. Continue your due diligence process until you're confident one way or the other. As a start, add it to My Watchlist to find all of our Foolish analysis.
To see the stocks that I've researched beyond the initial numbers and bought in my public real-money portfolio, click here.
At the time thisarticle was published Anand Chokkavelu doesn't own shares in any company mentioned. The Motley Fool owns shares of Wal-Mart Stores. Motley Fool newsletter services have recommended buying shares and creating a diagonal call position in Wal-Mart Stores. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.