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 Bristol-Myers Squibb (NYS: BMY) and some of its closest peers.
ROE (5-year avg.)
EBIT Margin (5-year avg.)
EBIT Growth (5-year avg.)
Total Debt/Equity (%)
Pfizer (NYS: PFE)
Johnson & Johnson (NYS: JNJ)
Eli Lilly (NYS: LLY)
Source: Capital IQ, a Standard &Poor's company.
We see some pretty intriguing figures appear across the board here. Bristol-Myers, J&J, and Eli Lilly all produced returns on equity well above most companies over the last half decade. These companies all generate really impressive operating margins and have safe capital structures to boot. While growth has been somewhat of a problem for some of these firms, and remains a lingering problem going forward, I do like Bristol-Myers's and Eli Lilly's historical growth. However, their performances only constitute one side of the price-to-value equation.
How cheap does Bristol-Myers Squibb 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
Johnson & Johnson
Source: Capital IQ, a Standard &Poor's company.
We see some of the bearishness surrounding these companies firsthand in the multiples the market places on them. Eli Lilly looks incredibly cheap, having the lowest cash flow and earnings multiples out of the firms reviewed here. Pfizer also looks like a steal judging by its cash flow multiple alone. Bristol-Myers, Pfizer, and J&J all look tempting, trading in the mid-teens relative to their earnings.
Investing in these companies, especially now, has as much to do with understanding their past as it does with understanding their future. These companies have struggled to find new breakthrough drugs to buoy their earnings into the medium term. While all these companies look pretty attractive, you'll really need to examine what's coming down their product pipeline in order to make an astute investment decision.
While Bristol-Myers Squibb might be 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 Johnson & Johnson.Motley Fool newsletter serviceshave recommended buying shares of Pfizer and Johnson & Johnson.Motley Fool newsletter serviceshave recommended creating a diagonal call position in Johnson & Johnson. 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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