A brutal July for energy stocks has a silver lining. Valuation levels in the sector have made great strides toward attractiveness for longer-term investors. But, as has consistently been the case with energy stocks in the past 12 months, there's a catch.
Price-to-cash-flow multiples have been the most popular and effective gauge of value for energy stocks. The accompanying charts focus on forward price to cash flow – stock prices divided by the average analyst estimate of cash flow for the next 12 months. This is because I think that estimates are a better gauge of future performance than the actual trailing 12 month cash-flow generation. The oil price averaged $65 a barrel (U.S.) in the past year, almost $20 a barrel higher than today.
The first chart, below, shows the cash flow multiple and performance of the S&P/TSX energy index (which includes energy services companies and natural gas producers). The light grey line represents the average forward cash flow multiple for the past three years – 7.2 times. At 7.6 times, the broad energy sector is currently trading only slightly above the three-year average.
The bottom chart compares the path of the more narrowly focused S&P/TSX oil producer index with the forward-price-to-cash-flow valuation. The sharp slide in the index – it's down 37 per cent since mid-April – has left producer stocks attractively valued relative to recent history. The three-year average price-to-cash-flow multiple is 6.0 times and the current average reading for the benchmark is 5.5 times.
Now the catch. The median forecast for the early 2016 West Texas intermediate crude price is $64.75, according to Bloomberg data. We can easily speculate that the cash-flow estimates for individual stocks are based on a commodity price in this range. In other words, cash-flow expectations are currently too high.
Unfortunately, the current WTI spot price is much much lower than those estimates, at around $46 a barrel. This strongly suggests that current cash-flow projections are set to be adjusted downward to reflect the lower than expected commodity price. As cash-flow expectations decline, the price-to-cash-flow multiples rise and stocks become more expensive and less attractive, even if the stock price stays the same.
The cash-flow multiples in the chart represent an average for a large number of stocks. The fact that average valuations are at least close to fairly valued implies that some stocks within the indexes could be trading at bargain levels.
Bargain-hunting investors will have to make sure that cash-flow growth and revenue prospects are extremely solid and unlikely to be reduced significantly before adding any positions to their portfolios.