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:
- The business' ability to generate profits.
- 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, business quality varies 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 owners greater value than a stagnant or declining business (duh!). However, many investors 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 Ace Limited (NYSE: ACE ) and some of its closest peers.
|
Company
|
Return on Equity (5-Year Avg.)
|
EBIT Margin (5-Year Avg.)
|
EBIT Growth (5-Year Avg.)
|
Total Debt / Equity
|
| Ace Limited |
14.30% |
20.92% |
35.93% |
27.44% |
| Allstate (NYSE: ALL ) |
9.25% |
8.46% |
63.78% |
30.87% |
| Progressive (NYSE: PGR ) |
16.66% |
10.32% |
(3.74%) |
31.43% |
| Travelers (NYSE: TRV ) |
14.54% |
21.28% |
18.33% |
26.19% |
Source: Capital IQ, a Standard &Poor's company.
Overall, Ace Limited's numbers look pretty impressive. It generates a slightly below average return on equity, in part due to its very conservative capital structure. However, I do like its margins and growth (growth).
Allstate appears conservatively financed and able to grow its business far better than any of its peers. On the other hand, it has the weakest returns on equity and margins.
Progressive produces the highest returns on its equity while not needing to leverage itself to achieve this. Unfortunately, the goods news stops there. It has relatively weak EBIT margins. Its negative growth strikes me as a serious negative.
Travelers' figures resemble Ace's. It has a slightly subpar ROE figure and a healthy EBIT margin. While lacking some of Ace's growth, growing your EBIT close to 20% a year still seems pretty impressive to me. I also like its safe capital structure.
How cheap does Ace Limited 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 companies' stock.
|
Company
|
Enterprise Value / FCF
|
P / LTM diluted EPS Before Extra Items
|
| Ace Limited |
7.55 |
8.83 |
| Allstate |
6.64 |
12.74 |
| Progressive |
9.72 |
12.37 |
| Travelers |
10.20 |
8.40 |
Source: Capital IQ, a Standard &Poor's company.
Based on these two figures, these companies all look cheap. They all have established, relatively strong businesses. Typically, such companies fetch higher multiples.
These companies all look like solid risk-reward propositions on paper. However, anyone considering investing in insurance companies needs to recognize the difficulty in understanding these highly complex organizations. You'll certainly want to read more about these firms before you consider buying them.
While Ace Limited looks like a potential stock for your portfolio right now, 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, further examining a company's quality of earnings, management track record, or analyst estimates is a great way to further your search for portfolio winners. You can also stop by Motley Fool CAPS, 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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