There are good reasons to believe that for oil-patch investors, trailing price-to-earnings and price-to-cash flow valuation methods won't be of much use in the months ahead. The 26-per-cent drop in North American crude prices since June means that for many domestic energy companies, profit and cash flow for the next 12 months are likely to be lower than those in the past year.
A closer look at forward price-to-cash flow multiples, however, suggests an outlook for Canadian energy stocks that is far more optimistic than the slide in the commodity price might suggest. Diligent investors should feel comfortable searching for bargains.
Using the S&P/TSX Energy Index, the chart compares the price-to-forward cash flow multiple, based on analyst estimates for the next year, to future performance of the sector. As we'd expect, the lines on the chart move in opposite directions – higher price-to-forward cash flow multiples are associated with lower future stock prices. Expensive stocks mean lower potential returns.
The current state of valuations is encouraging. The price-to-estimated cash flow ratio is 6.5 times – well below the 7.5 multiple where periods of weak future performance have occurred. It is also well below the post-crisis average of 7.1 times.
The resilience of Canadian energy stocks' profit growth is another important factor. The recent volatility in the sector was jarring in its suddenness, but so far the damage is not quite as bad as the May to October period in 2011. Then, the energy index plummeted almost 30 per cent after a 17 per cent drop in the oil price. Of importance, however, cash flow for the sector as a whole fell only 7 per cent in the aftermath.
For now, the outlook is constructive for energy stocks based on valuation levels. The situation would, of course, change if the WTI crude oil price starts another significant move lower and winds up well below $80 (U.S.) a barrel.
The potential effects of a weakening global economy on commodity prices implies that investors should remain cautious.
There was clearly panic selling in energy markets last week. And, despite the strong rallies on Thursday and Friday, even the dominant franchises of Suncor and Canadian Natural Resources are still trading at attractive valuation levels relative to historical averages. Market history and valuations suggest this is an excellent time to start a dollar-cost-averaging strategy in large-cap domestic energy stocks.