What are we looking for?

Today we are looking at the ability of energy companies to generate superior profits based on their return on capital.

Matt Kacur, president of FSA Financial Services & Art Ltd. of Toronto, has developed and licenses a software to undertake a quantitative and mathematical analysis to determine future profitability.

The Return on Capital Report is done in conjunction with Haywood Securities Inc. analysts, who provide the analytic assessments of companies in the screen to adjust discrepancies between the model’s valuation and the current stock prices. This helps identify changes in trends and outlook to determine undervalued and overvalued companies.

More about the screen

Most investors look at a company’s earnings to see how profitable a company is. But earnings per share can be distorted by items such as amortization and depreciation. Some investors would rather look at calculations such as return on capital, which measures how well a company generates cash flow relative to the capital it has invested in its business.

The ROC Report analyzes about 180 companies that ranks them according to their cash flow internal rate of return. Today, we’re just looking at the energy companies included in this report.

The final analysis produces a quarter-by-quarter screen that sizes up a company’s ability to generate a return on invested capital (total assets plus accumulated depreciation), which is adjusted for inflation before the short-term liabilities are deducted.

The return is based on the present value of the cash flow over the estimated life cycle of the assets. The cash flow calculation is made by putting debt and equity on an equal footing by adjusting the operating profit by a normalized tax rate.

How has the report performed?

The report generates two portfolios, one small capitalization and the other a large cap. Each portfolio is a list of 20 to 30 companies. Since its inception in early 2003, the small-cap portfolio has generated an annualized rate of return of 19.8 per cent, while the large-cap portfolio, which was started a year later, has an annual return of 8.1 per cent. Both have outperformed their comparative indexes on the S&P/TSX.

Today’s focus on energy companies reflects its importance in the performance of the Canadian stock market. “Oil and gas is really quite strong despite the rhetoric on alternative energy,” Mr. Kacur said.

However, the latest ROC report is slightly underweight energy with a 26.1 per cent weighting, compared with 26.9 per cent energy weighting in the S&P/TSX. “We tend to outperform not because of the sector weightings,” Mr. Kacur said. “We try to pick the best companies in the sector.”

What we found

In the table today, we present the Top 10 most undervalued energy companies, according to Haywood Securities.