Does DryShips Look Like a Winning Investment?

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 five-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 DryShips (NAS: DRYS) and some of its closest peers.

Source: Capital IQ, a Standard &Poor's company.

The shipping industry really thrived in the run up to the Great Recession. However, for several reasons, shippers have been in the doldrums since the housing bubble popped. They typically have pretty generous operating margins, and their past growth looks phenomenal. But because the industry requires substantial capital investments (ships don't come cheap!), these companies typically have to carry pretty substantial debt burdens. In particular, Eagle Bulk and Genco look somewhat risky.

How cheap does DryShips 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.

Source: Capital IQ, a Standard &Poor's company.

The industry dynamics also reveal themselves here. We see the negative cash flow result from substantial capital expenditures.

These stocks might look like a great value play on the surface. However, the industry dynamic going forward should mostly influence your investment decisions in dealing with the shipping industry. Shipping rates have been absolutely decimated since the beginning of the Great Recession. To make matters worse, a glut of new ships have recently come on line, making the prospects of decreased profitability an unfortunate reality. These stocks looks great on paper, but their best days are likely behind them. Buyer beware.

While DryShips stock doesn't look 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. 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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