The Vodafone (LSE: VOD) share price looks quite attractive at first glance. The stock is trading at around 150p, slightly below its 52-week high of 165p, and significantly below its five-year high of 250p. However, from an earnings perspective, the stock looks quite expensive.
It is currently dealing at a price-to-earnings ratio of 22.6 for the 2020 financial year. But looking at the company’s earnings figure alone gives something of a misleading picture.
A better way to value the business
You see, Vodafone owns a lot of capital equipment, such as telecoms masts, buildings and data centres. Accounting rules and regulations require these assets to be depreciated, which appears as a charge on the income statement.
This is an accounting charge only and has no impact on the company’s underlying cash flows.
As a result, when evaluating companies like Vodafone, which have lots of capital assets, price-to-free-cash-flow tends to be a better valuation metric over the P/E ratio. The same can be said for the EV/EBITDA multiple, as this strips out the distorting effect of depreciation on earnings. It also takes into account debt.
On both of these metrics, Vodafone looks much more attractive. The stock is trading at a price-to-free-cash-flow ratio of 7.3, compared to the telecommunications industry median of 13.7.
What’s more, it is trading at an EV/EBITDA ratio of 6.5 compared to the industry median of 9.8. These metrics imply the Vodafone share price is trading at a discount of 47% and 34% respectively to the industry average.
The above figures seem to suggest that the Vodafone share price is an unmissable bargain at current levels.
As well as the discount valuation, the stock also supports a dividend yield of 5.4% at the time of writing. So it looks as if investors will be paid to wait for the share price recovery.
That being said, the one thing that does concern me is the company’s level of debt. Vodafone’s debt has ballooned in recent years as the group has been forced to spend more on upgrading its infrastructure, and bidding for mobile spectrum rights around the world.
Management is trying to get these liabilities under control, but progress is slow.
The company is plotting a spin-out of its tower business and cut its dividend earlier in 2019 to save cash.
In my opinion, Vodafone’s level of debt justifies the company’s discounts to the rest of the sector. Hopefully, we should have some more progress on debt reduction in 2020, and when we do, I think there is a good chance the market could re-rate the stock higher and this should send a signal to the market that the dividend is safe from further cuts.
The bottom line
So overall, the Vodafone share price does look cheap at current levels, but until the company gets its debt mountain under control, I think the market is likely to continue to give the stock a wide berth.
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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.