There are many ways to value a company. Price to earnings. Price to cash flow. Liquidation value. Price per eyeballs on website. Price to a number I made up (this one never gets old). Price to CEO's ego divided by lobbying activity as a percentage of revenue (this one doesn't get used enough).

Which one is best? They're all limited and rely on assumptions. No metric holds everything you need to know.

This one is no different. But it's perhaps the most encompassing, and least susceptible to hidden complexities of a company's financial statements. The more I think about it, the more I feel it's one of the most useful metrics out there.

What is it? Enterprise value over unlevered free cash flow.

  • Enterprise value is market capitalization (share price times shares outstanding) plus total debt and minority interests, minus cash.
  • Unlevered cash flow is free cash flow with interest paid on outstanding debt added back in.

The ratio of these two statistics provides a valuation metric that takes into consideration all providers of capital -- both stockholders and debtholders.

But you invest in common stock, so why should you care about bondholders? Ask Lehman Brothers investors why. When a company earns money, it has to take care of bondholders before you, the common shareholder, gets a dime. Focusing solely on profits in relation to equity can be dangerously misleading.

Enterprise value provides a more encompassing view. By bringing debt capital into the situation, we see real earnings in relation to the company's entire capital structure. If you owned the entire business, this is the metric you'd naturally gravitate toward.

Using this metric, here are four companies I found that look attractive.

Company

Enterprise Value/ Unlevered FCF

5-Year Average

 

CAPS Rating
(out of 5)

Berkshire Hathaway (NYS: BRK.B) 7.8 13.6 *****
Pfizer (NYS: PFE) 8.2 11.8 ****
ConocoPhillips (NYS: COP) 9.4 13.4 *****
Waste Management (NYS: WM) 19 24 *****

Source: Capital IQ, a division of Standard & Poor's.

Let's say a few words about these companies.

Berkshire Hathaway
You don't need much introduction to Berkshire Hathaway. It's run by the greatest investor in the world. You can usually just end there.

Alas, Warren Buffett's mortality has given plenty of investors pause, wondering what the future of Berkshire will look like in a post-Buffett world. This is especially concerning for Berkshire investors, who tend to be a very long-term-focused bunch.

I think there are two important points to make here. One, Berkshire will thrive long after Buffett. The collection of businesses Buffett has built up over the years doesn't rely on his day-to-day management. GEICO will sell just as many insurance policies. Coca-Cola (NYS: KO) will sell just as much soda. Burlington Northern will haul just as much freight. Life will go on.

More importantly, it's hard to say there's a so-called "Buffett premium" in Berkshire's stock anymore. The company trades at the lowest valuation it has in decades, barely holding a premium to book value.

And let's be honest: The man is as sharp as he's ever been. It's not unreasonable to think Buffett could run Berkshire effectively for another decade.

Pfizer
I like reading old news. This might sound dull, but it provides insight into what people were thinking at a point in time, and allows you to go back and see where they went wrong and what they got right.

When reading investment news from the late 1990s, nearly everyone was wildly bullish on pharmaceuticals like Pfizer. This is fascinating -- or perhaps perfectly expected -- because Pfizer has since lost over half its value.

What went wrong? Two things. One, patent expirations have shaved these companies' growth prospects considerably. Two, and far more important, valuations were astronomical 10 years ago.

Growth prospects are still dismal today. But valuation-wise, things couldn't be more different. Big pharmaceutical companies like Pfizer trade at some of the lowest valuations and offer some of the highest dividends in the market. That sets the stage for future returns. At a high valuation, even great news can lead to terrible returns. At a low valuation, even bad news can lead to above-average returns. I have a feeling the next 10 years will look nearly the opposite of the past 10 for Pfizer.

ConocoPhillips
Big oil companies in general have offered some of the best returns of the past decade. Most of the reason is obvious: Oil prices have surged.

But it's more than that. Big oil companies have one of the better histories of capital allocation, offering share buybacks and dividends in greater -- and smarter -- amounts than many other industries.

ConocoPhillips, for example, has returned nearly $40 billion to shareholders in the form of dividends and buybacks over the past five years. Against a current market cap of $92 billion, that's an attractive return -- particularly if you assume the company (and its impending spinoffs) will be able to grow free cash flow at decent rates over the coming years. You won't blow the lights out with a company like Conoco, but it can be great for the "get-rich-slowly" type of investor who appreciates the power of compounding.

Waste Management
Last week, my colleague Matt Koppenheffer wrote about the most important part of investing: moats. Waste Management is a good example. Its size provides economies of scale -- profit advantages over smaller competitors due to lower average fixed costs. Being a giant also adds so-called "learning by doing" advantages. Waste Management has picked up so much trash over the years that it has the process down to a science.

Better yet, the stock has plunged lately, down by almost a fifth since April. This is a high-quality company trading at a good price and clouded by pessimism. Take advantage of that.

Interested in more?

At the time this article was published Fool contributor Morgan Housel owns shares of Berkshire. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Coca-Cola, Waste Management, and Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Coca-Cola, Berkshire Hathaway, Waste Management, and Pfizer. Motley Fool newsletter services have recommended creating a write covered strangle position in Waste Management. 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.

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The next 10 years will be good? Yeah, right! With Lipitor revenue about ready to go from $11B to zero in a few months, and nothing to replace it, how in hell does the author think the next decade will be good? PFE has screwed shareholders over the last 15 years...now that's a trend worth taking to the bank! C'mon, get real!

September 19 2011 at 2:40 PM Report abuse rate up rate down Reply