There are a number of different ways investors can try to assess whether a given stock is cheap. Whether that’s via its share price (typically a reflection of the market’s perception of its growth prospects), its valuation, dividend yield, or a range of other metrics, diverging opinions on a specific company can quickly emerge.
I tend to focus on valuations and how multiples expand or contract over time as the key indicator as to whether a given company is undervalued or not. In this piece, I’m going to highlight why I think Northland Power (TSX:NPI) could be among the cheapest TSX stocks out there.
Let’s dive in!
Source: Getty Images
Valuation multiples are historically cheap
Following a decline of around 60% over the past five years (shown in the chart above), one might expect to see some significant multiple contraction with Northland Power. That is certainly the case.
The company’s forward price-to-earnings multiple now sits around 12 times. When I started covering this stock years ago, Northland Power was typically good for a forward multiple above 30 times, so that’s a dramatic drop.
A number of analysts have put forward discounted cash flow models, which should have NPI stock trading around the $40 level. But with this stock down to around $17.50 at the time of writing, that’s a very large discount to where this stock should be trading — at least, on the basis of its cash flows (how I value stocks myself).
Does this mean Northland is a buy or a value trap?
When high-quality companies like Northland with premium assets in a sector I still think has long-term growth potential (that of renewable energy) see valuations decline like this, investors have to ask a key question. Is this decline the result of some sort of structural issues that will impair Northland’s cash flows over the next five to 10 years?
If the answer to this question is yes, Northland could certainly be a value trap. That’s a possibility, and it needs to be at the back of investors’ minds. No matter how far a stock has fallen, it can fall further. And if we do see a continued shift toward fossil fuels and away from renewable energy, perhaps this will be the case.
I’m going to suggest, however, that the current political dynamics, which do not favour companies like Northland, are likely to change. My base case is that a shift in political priorities in the next three years should drive a big rally in Northland. Now, the question is just how patient investors want to be in waiting for such a rebound.
I think Northland’s rock-bottom valuation and dividend yield of 6.7% provides enough enticement for investors to wait. That’s my view.
