They say that some things are too good to be true. The same can go for high-yielding stocks that are selling at very low valuations. It's easy to run a basic screen that finds companies that yield a high dividend and sell below a targeted P/E ratio. But identifying these companies is not enough. That's only when the real work begins.
To really determine why the valuation of a company is depressed, a Fool needs to pore over financial statements, listen to management's quarterly conference calls, and understand why the market holds its current view.
Make no mistake: Just because a company has a low P/E ratio and pays a nice dividend, it's not any less risky.
Two traps and one potential winner
Take a look at these three companies: Collectors Universe (Nasdaq: CLCT), Garmin(Nasdaq: GRMN), and EarthLink (Nasdaq: ELNK). All three are yielding about 5% or better with P/E ratios less than 10, but have varying prospects.
This micro cap is trading at a mere P/E of seven and has a yield that is expected to be around 9%. Sound like an unbelievable bargain? Well a closer look at the numbers reveals that when you normalize EPS to remove discontinued operations and the release of a valuation allowance, the company is trading at a more reasonable level of 15.
While this isn't exactly high, it isn't the screaming bargain that it appeared to be before. You'd also have to be concerned with the company's ability to generate the same level of normalized profit in fiscal 2011, given its inconsistent earnings history.
With no guidance from management for the upcoming fiscal year and after the first quarter of fiscal 2011 didn't measure up to the prior year's comparable quarter, this one may have more risk than I'm willing to take.
This is yet another company with very attractive valuation metrics with a P/E of nine and a yield of 4.7%. But this one has warning signs as well, albeit different than those of Collectors Universe above.
While there are smaller one-time items in their numbers, Garmin still remains cheap overall. But before you conclude that this is just another case of Mr. Market's inefficiencies, you should consider why this company is selling at such low valuations.
With shrinking margins and a product that seems to be drifting into obsolescence by the emergence of smartphones sold by Apple or running on software from Google, Garmin may deserve to be cheap. Sure, maybe management will be able to combat these new competing technologies or explore new markets, but those prospects hardly seem like a safe bet. Seems like a classic dividend trap to me.
At first peek, EarthLink seems to be similar to our companies above. This has a yield of 7.1% and a P/E of four, so something has to be up, right? Well, we have another valuation allowance release that is affecting EPS for the trailing 12 months, so the earnings supporting that P/E ratio need to be adjusted.
After backing that out, the P/E is still only 11, which is pretty low. Looking at EV/FCF, the news is even better with an EV of $542 million on $166 million of free cash flow for a whopping 3.3 multiple. That's pretty good cash generation for a company that size. Even after accounting for a recent acquisition that closed in the fourth quarter, enterprise value nearly doubles to $1,066 million, and you'd have to assume that this is only going to propel the underlying cash flow.
Skeptics would say that EarthLink's bread and butter -- dial-up Internet -- is a dying business much like that of its rumored acquisition target, AOL (NYSE: AOL). While that may be the case and the reason for this valuation, there will continue to be a need for this less expensive service in the future as not everyone can afford broadband. And in the meantime, EarthLink should continue to throw off plenty of cash from its subscription-based business that can be given back to its shareholders in the form of dividends. To me, this one has the potential to be a winner.
Don't let a low valuation convince you that an investment is low risk. None of the above companies is a safe, widows-and-orphans stock like AT&T (NYSE: T) -- which also fits the criteria above -- that has consistently paid a dividend for years. But there is room in a diversified portfolio for higher risk companies, which necessarily require a higher return to compensate for this risk.
While my preliminary research piques my interest in EarthLink, this is really just the tip of the iceberg. Only through a more thorough analysis will a Fool be able to conclude whether EarthLink is a trap or a legitimate case of dividends on sale.
© 2010 UCLICK L.L.C.