Closing at $88.97 and $431.72 on March 8, respectively, Exxon Mobil (NYSE:XOM) and Apple (NASDAQ:AAPL) are both worth approximately $400 billion — a price that makes them relatively undervalued stocks according to a research note circulated by Morgan Stanley on Monday.
As analyst Adam Parker wrote in his explanation, seen by Barron’s, the reasoning for such an assessment is simple; now is the time to judge a stock by its free cash flow rather than dividend yield or earnings. “Investors retreated from growth-oriented stocks in February, as these factors did not work, following a strong period,” he wrote. “Instead, stocks with high free cash flow did well, continuing a run that began last summer.”
Although the United States equity markets have generally shrugged off the uncertainty of Washington’s fiscal policy plans in recent weeks, the negotiations still pose a risk to market participants. As a result, investors are looking away from growth-oriented stocks — meaning the stock of a company with earnings growing faster than the overall market — and toward defensive bets. Companies with strong free cash flow represent such an option to Parker…
Parker’s metric — free cash flow — represents the dollars available to a company’s management to be used where most needed; the money can be reinvested back into the business, it can pay down debt, or be funneled to investors to fund share repurchases or dividends. Even more importantly, strong cash flow indicates that the company is generating money, allowing it to avoid having to tap the capital markets or sell off parts of its business. “Free cash flow is one of the best long-run factors, so the recent rise in stock-specific risk may be renewing attention to it,” explained Parker.
In the most recently-reported quarter, Apple reported free cash flow of $23.4 billion, while Exxon reported a figure of $56.17 billion.
The other factor that Parker took into consideration was price; high dividend yielders are typically more expensive than high free cash flow yielders. “As measured by forward price-to-earnings (on a common set of stocks with both positive dividend yield and valid free cash flow), Q1 dividend yield has been historically expensive compared to Q1 free cash flow yield since June 2012,” he stated.
In terms of both Apple and Exxon, he believes that while the long-run valuation chart shows that “there have been valuation gaps between dividend yield and free cash flow yield,” these gaps “have not grown too large or persisted indefinitely.”
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