What are we looking for?
Non-financial companies that generate enough value to minimize their reliance on debt.
In the economic value added (EVA) approach, we use return on capital rather than return on equity to analyze companies. Essentially, the return on capital ignores the effect of leverage to provide a clearer picture on the business fundamentals.
The key idea is that you can always turn an efficient, low-leverage company into an extraordinary one by adding leverage, but you can’t make a poorly performing company great simply by increasing its leverage.
Today, we’ll focus on identifying fundamentally sound, low-leverage companies poised for growth.
The screen
We screened non-financial Canadian stocks using the following criteria:
- market capitalization greater than $1-billion;
- long-term debt/NOPAT ratio under 3 – A higher ratio suggests higher indebtedness. NOPAT (net operating profit after taxes) assesses a company’s operating profitability. This ratio focuses exclusively on long-term debt rather than total debt.
- EVA-to-capital greater than 7 per cent – This metric evaluates how much value the company creates with its capital. Value is defined as NOPAT minus cost of capital.
- earnings per share greater than two years ago and most recent earnings must be positive.
- price-to-intrinsic-value ratio lower than 1.5. The intrinsic value is derived from a discounted cash flow model. (Discounted cash flow is a measure of expected future cash flows.) The inputs are automatically selected by our algorithms. A ratio below 1 suggests that the stock is inexpensive.
For informational purposes, we have also included, price-to-earnings ratio, price-to-NOPAT ratio and one-year price return.
More about Inovestor
Inovestor is a Canadian fintech company with more than 20 years of experience that has partnered with Morningstar in an alliance, solidifying Inovestor’s position as the industry’s leading alternative analysis tool. To learn more visit our website.
What we found
Low-leverage value creators
Topicus.com, TOI-X a software company that focuses on vertical market products and was spun off from Constellation Software Inc. in early 2021, is traded on the TSX Venture Exchange despite a market value of $11-billion. It tops our list with an EVA-to-capital of 22.5 per cent. Although it has a high P/E ratio of 95, our system deems it undervalued, giving it a P/IV of 0.8. Its price-to-NOPAT ratio is 15.8, positioning it in the middle of our list. Our software might be uncovering unique insights about this stock that aren’t entirely reflected in traditional accounting profits.
Hammond Power Solutions Inc., HPS-A-T known for manufacturing dry-type transformers and related magnetics for emerging technologies such as fast chargers for electric vehicles and renewable energy, operates with minimal debt, as indicated by its long-term debt to NOPAT ratio of 0.1. Currently, it is the priciest company on our list, based on a price-to-NOPAT ratio of 23.4., but the least based on its price-to-intrinsic value of 0.5. The company has experienced impressive price momentum, having surged 87.2 per cent over the past year.
Terravest Industries Inc., TVK-T which provides equipment and services for the energy and industrial sectors, utilizes a moderate amount of debt, evidenced by a debt-to-NOPAT ratio of 2.2. Valuation metrics, including P/E and P/NOPAT ratios of 26.3 and 17.1, respectively, indicate that the company is more expensive than the median on our list. However, our P/IV metric, at 0.7 and ranking as the third lowest on our screen, may reveal additional insights. Interestingly, the stock has surged by 163.2 per cent over the past year.
Investors are advised to do further research before investing in any of the companies listed in the accompanying table.
Anthony Ménard, CFA, is vice-president of data management at Inovestor.
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