As investors, we always want our investments to generate a healthy return. However, investors often forget that returns stem from two, not one, extremely important factors:
1) The business's ability to generate profits.
2) The price you pay for one share of those profits.
This idea of price versus returns provides the bedrock for the school of investing known as value investing. In this series, I'll examine a specific business from both a quality and pricing standpoint. Hopefully, in doing so, we can get a better sense of its potential as an investment right now.
Where should we start to find value?
As we all know, the quality of businesses vary widely. A company that has the ability to grow its bottom line faster (or much faster) than the market, especially with any consistency, gives its owner greater value than a stagnant or declining business (duh!). However, many investors also fail to understand that any business becomes a buy at a low enough price. Figuring out this price-to-value equation drives all intelligent investment research.
In order to do so today, I selected several metrics that will evaluate returns, profitability, growth, and leverage. These make for some of the most important aspects to consider when researching a potential investment.
Return on equity divides net income by shareholder's equity, highlighting the return a company generates for its equity base.
The EBIT (short for earnings before interest and taxes) margin provides a rough measurement of the percent of cash a company keeps from its operations. I prefer using EBIT to other measurements because it focuses more exclusively on the performance of a company's core business. Stripping out interest and taxes makes these figures less susceptible to dubious accounting distortions.
The EBIT growth rate demonstrates whether a company can expand its business.
Finally, the debt-to-equity ratio reveals how much leverage a company employs to fund its operations. Some companies have a track record of wisely managing high debt levels; generally speaking, though, the lower the better for this figure. I chose to use 5-year averages to help smooth away one-year irregularities that can easily distort regular business results.
Keeping that in mind, let's take a look at Abbott Laboratories (NYS: ABT) and some of its peers.
ROE (5-year avg.)
EBIT Margin (5-year avg.)
EBIT Growth (5-year avg.)
Total Debt/Equity (%)
Medtronic (NYS: MDT)
Novo Nordisk (NYS: NVO)
Insulet (Nasdaq: PODD)
Source: Capital IQ, a Standard &Poor's company.
Abbott, Medtronic, and Novo appear to be in a class of their own here. They all exhibit strong past ROEs, operating margins, and growth (albeit with Novo leading by a pretty wide margin). They all appear to have safe capital structures as well. Insulet, on the other hand, has really only bled money over the last five years.
How cheap does Abbott Laboratories look?
To look at pricing, I chose to look at two important multiples, price to earnings and enterprise value to free cash flow. Similar to a P/E ratio, enterprise value (essentially debt, preferred stock, and equity holders combined minus cash) to unlevered free cash flow conveys how expensive the entire company is versus the cash it can generate. This gives investors another measurement of cheapness when analyzing a stock. For both metrics, the lower the multiple, the better.
Let's check this performance against the price we'll need to pay to get our hands on some of the company's stock.
P/LTM diluted EPS before Extra Items
Source: Capital IQ, a Standard &Poor's company. * NM = not measurable.
We see some pretty cheap multiples at work here. Medtronic looks especially cheap, trading at nearly 10 times cash flow and net income. Similarly, Abbott Labs also looks reasonably attractive. Novo Nordisk looks slightly too expensive, while Insulet looks like a stock to avoid.
In total, only Abbott Labs and Medtronic look like potential winners. Novo Nordisk might also deserve some investigation, but I'd probably want to buy at lower multiples. If Insulet manages to develop a marketable product, their business could turn around significantly. However, their past performance makes me want to take my search for investment riches elsewhere.
While Abbott Laboratories looks like a winning stock on the surface, the search doesn't end here. In order to really get to know a company, you need to keep digging. If any of the companies mentioned here today piques your interest, then further examining a company's quality of earnings, management track record, or analyst estimates all make for great ways to further your search. You can also stop by The Motley Fool's CAPS page, where our users come to share their ideas and chat about their favorite stocks, or click here to add them to My Watchlist.
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At the time thisarticle was published Andrew Tonner holds no position in any of the companies mentioned in this article. The Motley Fool owns shares of Medtronic and Abbott Laboratories.Motley Fool newsletter serviceshave recommended buying shares of Abbott Laboratories. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.
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