What are we looking for?
Large-cap Canadian stocks trading at optimistic valuation levels, which could signify they are currently overvalued.
The screen
We screened the S&P/TSX composite index with the following criteria:
- A future-growth-value-to-market-value ratio of 50 per cent or higher. FGV represents, in percentage, the portion of the market value that exceeds the company’s current operating value. The higher the number, the higher the baked-in premium for expected growth, and the higher the risk;
- An economic performance index, or EPI (return on capital divided by cost of capital) of maximum 1.0. An EPI ratio of 1.0 or more indicates a company’s capacity to create wealth for its shareholders (a higher EPI displays a greater rate of wealth creation). In this filter we are looking for companies that are unable to generate positive wealth for shareholders;
- A negative (or at least not positive) change in return on capital over 12 months and 24 months.
- A negative free-cash-flow-to-capital ratio. This ratio gives a sense of how well the company uses the invested capital to generate free cash flow, which could be used to stimulate growth, pay and/or increase dividends, reduce debt, etc. A negative number means the company burns cash through its operations.
- The return on capital, debt-to-equity ratio, dividend payout ratio and dividend yield are displayed for informational purposes.
More about StockPointer
StockPointer is a fundamental analysis tool based on an EVA (economic value-added) model to quickly and easily identify investment opportunities. In addition to providing detailed reports on more than 7,500 companies (Canadian stocks, U.S. stocks and American depositary receipts), StockPointer also allows investors to create personalized filters and build custom portfolios.
What did we find?
Ten companies show up in our results, most of which are in the energy or materials sectors. The key metric of this filter is the future-growth-value-to-market-value ratio. If we look, for example, at NexGen Energy Ltd.'s future-growth-value ratio of 89 per cent, it means only 11 per cent (100 minus 89) of the enterprise value is justified by the current profit. In other words, the company must deliver strong results and at least meet expectations for its stock to stay at this level. Companies with such high baked-in premiums are exposed to bigger corrections when they miss estimates and/or lower their guidance. Other companies such as Pason Systems Inc. and ShawCor Ltd. that display a negative payout are also potential red flags. Paying a dividend while the company generates losses and negative free cash flow can be fine for a short period, but if this pattern is consistent, the management could decide to cut or eliminate the dividend. A payout ratio of 100 per cent or above is not ideal either because it means the dividend amount the company distributes is higher than its earnings, but at least the company is profitable.
Investors are advised to do additional research prior to investing in any of the companies mentioned.
Jean-Didier Lapointe is a financial analyst at Inovestor Inc.