New Way To Analyze Solar Stocks
by Tushar Mathur - October 27th, 2009. Filed under: Solar Stocks.Fist let me start by saying that I personally hold solar stocks:
Having said that, here is a novel approach, that I read about, to valuing solar stocks.
Given the inherent nature of the solar manufacturing industry (i.e., manufacturing a commodity product used to generate electricity), as well as the highly leveraged balance sheets, we believe that enterprise value (EV) multiples (instead of price to earnings) should be used for solar stocks.
Additionally, solar industry multiples should be compared to a mix of industrial, infrastructure (selling product/services to utilities), utilities and other forms of alternative energy sectors (such as wind and smart grid/metering).
You could be using EV multiples because the majority of solar manufacturers have leveraged balanced sheets, with debt-to-equity ratios in the range of 90% to 100%. You could also use return on net assets to compare solar stocks with each other as well as to compare them with other comparable industries (mentioned above).
This is critical since solar manufacturers are involved in making a commodity product (i.e., poly, cell, module, systems) that generates a commodity-type output (i.e., electricity); and, since there is little differentiation, it is then prudent to focus more on “asset” management as a means of differentiating companies.
There is little technological investment and differentiation among solar companies. To help illustrate this, the research and design commitment by solar companies is less than 5% of total revenues, versus double-digit percentages for tech-related companies!
Thus, investors are encouraged to separate good “asset” managers from average ones by using return on net assets.
Leading analysis indicates that, since solar stocks would need to be compared to other commoditized industries, average valuation multiples should be in the range of one times to two times EV to sales, with no multiple expansion. With that as a base, note that such solar companies as First Solar (ticker: FSLR) that have the best return on net assets do warrant a premium, though the debate on this particular topic has more to do with the question, “What is the most appropriate premium paid?”
How should investors think about return on equity (ROE)? We break up ROE into three components: (1) the net income margin, (2) asset turnover and (3) balance sheet leverage. Given the fact that solar companies have highly leveraged balanced sheets and that operating margins are permanently under pressure, it is the asset turnover that should be used to differentiate companies and determine which ones can yield higher ROEs.
What are the most appropriate valuation multiples for the solar companies? With the above as the necessary background:
– Solar stocks should be compared to industrial, infrastructure (especially the ones selling products/services to utilities), utilities and other forms of alternative-energy-related sectors (like wind and smart grid/metering).
– Solar stocks should be trading in a range of one to two times EV to sales.
– Solar companies, on average, are expected to have relatively higher return on net assets when compared to comparable industries, thus warranting higher EV multiples, but this has already been reflected in the one to two times EV/sales multiple range suggested above.
– Yes, First Solar has exhibited the best return on net assets, but we also argue that a premium that is more than four times the average solar stock EV multiple is too high.
– The above analysis becomes even more applicable to the solar industry as such companies move downstream (where there is little fixed cost).
This analysis could be applied to other solar companies like: