One of Wall Street's worst performers of the day is Alcoa Corporation, a aluminum company whose shares have slumped -8.5% to a price of $50.79, 12.76% below its average analyst target price of $58.22. The average analyst rating for the stock is buy. AA underperformed the S&P 500 index by -7.4% today but outpaced it by 23.3% over the last year with a return of 11.4%.
Alcoa Corporation belongs to the basic materials sector, which includes the chemical, coal, mining, aluminum, and steel industries. The demand for these materials is dependent on economic cycles: when the economy is growing, companies across all sectors ramp up production, which increases demand from basic materials companies.
Conversely, when the economy slows down, demand for these materials decreases. The stock prices of this sector tend to follow the ebbs and flows of these demand cycles -- but accurately predicting where we are presently in the economic cycle is a matter of intense debate.
As of the second quarter of 2022, the average Price to Earnings (P/E) ratio for US basic materials companies is 8.77, and the S&P 500 has an average of 15.97. The P/E ratio consists in the stock's share price divided by its earnings per share (Eps), representing how much investors are willing to spend for each dollar of the company's earnings. Earnings are the company's revenues minus the cost of goods sold, overhead, and taxes.
Alcoa corporation's trailing 12 month P/E ratio is 9.9, based on its trailing Eps of $5.14. The company has a forward P/E ratio of 7.1 according to its forward Eps of $7.12 -- which is an estimate of what its earnings will look like in the next quarter.
Earnings are the most widely used metric for understanding a stock's valuation. When considered alongside the company's revenue growth, they can also give insight into the company's margins, which in turn can allow us to make inferences about its possible competitive advantages. Alcoa corporation's year on year (YOY) quarterly earnings are growing at a rate of 81.0% and its YOY quarterly revenues are increasing at a rate of 28.6%.Since the earnings growth rate is higher than the revenue growth rate, we can deduce that the company's profit margins are widening. Companies can increase their earnings at a faster rate than their revenue by reducing their tax liability, raising prices, or cutting their overhead or the cost of goods sold.
In contrast with earnings, gross profits are calculated on the basis of the company's cost of goods sold (i.e. cost of labor and materials only) subtracted from sales revenues. Significant gross profit margins shed light on how much freedom the company has in setting the prices of its products. A wider gross profit margin indicates that a company may have a competitive advantage, as it is free to keep its product prices high relative to their cost. In AA's case, the gross profit margins are 28.3%, from which we can infer that its competitive advantage is probably not absolute, and is facing some pricing pressure from other companies within the same market.
The revenues and earnings related to sales are only a part of the financial puzzle of large corporations, which have many costs and expenses arising independently from their core business: cost of maintaining debt, rent payments, return on capital investments, depreciation, etc. When all of these separate cash flows are taken into account, we are left with the company's levered free cash flow, which for Alcoa Corporation is $898,875,008. With its positive cash flow, the company can not only re-invest in its business, it can offer regular returns to its equity investors in the form of dividends. Over the last 12 months, investors in AA have received an annualized dividend yield of 0.5% on their capital.
Another valuation metric for analyzing a stock is its Price to Book (P/B) Ratio, which consists in its share price divided by its book value per share. The book value refers to the present liquidation value of the company, as if it sold all of its assets and paid off all debts). Alcoa corporation's P/B ratio indicates that the market value of the company exceeds its book value by a factor of 1.6, but is still below the average P/B ratio of the Basic Materials sector, which stood at 1.85 as of the second quarter of 2022.
As of second quarter of 2022, Alcoa corporation is likely fairly valued because it has a high P/E ratio, a lower than average P/B ratio, decent profit margins, an analyst consensus of some upside potential, and strong cash flows. We hope this preliminary analysis will encourage you to do your own research into AA's fundamental values -- especially their trends over the last few years, which provide the clearest picture of the company's valuation.
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