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 approach known as value investing. In this series, I'll examine a specific business from both a quality and pricing standpoint. In doing so, I hope to provide 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 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 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.
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 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 percentage of cash a company keeps from its operations. I prefer using EBIT over 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 all that in mind, let's take a look at UnitedHealth Group (NYSE: UNH ) and some of its closest peers and companies across the health industry.
|
Company
|
Return on Equity (5-Year Average)
|
EBIT Margin (5-Year Average)
|
EBIT Growth (5-Year Average)
|
Total Debt / Equity
|
| UnitedHealth Group |
18.97% |
8.81% |
11.36% |
44.32% |
| Medco Health Solutions (NYSE: MHS ) |
17.28% |
3.61% |
20.51% |
139.78% |
| Express Scripts (Nasdaq: ESRX ) |
51.89% |
5.16% |
27.99% |
62.93% |
| CVS Caremark (NYSE: CVS ) |
11.57% |
6.41% |
30.00% |
25.76% |
Source: Capital IQ, a division of Standard & Poor's.
UnitedHealth Group looks decent on paper. It produced a respectable historical ROE and grew its operations reasonably well over the past five years. I also like its conservative capital structure. However, its growth seems to have significantly lagged its peer group, a red flag in my book.
Medco Health generated nearly the same ROE as UnitedHealth did during this same period. Its operating margin significantly lagged UnitedHealth's, but its growth really excelled. Its debt-to-equity ratio of better than 100% does give me some pause here as well, though.
Express Scripts looks like the strongest company out of this group. Its past ROE blows the competition away, and it made up for its anemic margin by growing the business well over the last five years. Its conservative financing also makes it appear pretty safe from a financial risk standpoint.
CVS Caremark shows some positive and some negatives. Its ROE leaves something to be desired on both a relative and absolute scale. And as with the other companies here, its weak margins give some cause for concern. On the other hand, it did grow its business exceptionally well over the past half-decade.
How cheap does UnitedHealth Group look?
To look at pricing, I've chosen to examine 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. The resulting figure 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.
|
Company
|
Enterprise Value / FCF
|
P / LTM Diluted EPS Before Extra Items
|
| UnitedHealth Group |
10.18 |
11.27 |
| Medco Health Solutions |
15.01 |
17.77 |
| Express Scripts |
21.86 |
24.86 |
| CVS Caremark |
16.41 |
15.70 |
Source: Capital IQ, a division of Standard & Poor's.
In looking at pricing, only UnitedHealth looks really cheap. The rest of the companies look to have quite a bit of growth still priced into them.
Depending on your opinion about these companies' growth going forward, they could deserve continued research. Even lacking the dramatic growth of the others, UnitedHealth is cheap enough to make it a potential candidate for consideration.
Although UnitedHealth Group could look like a stock for your portfolio right now, the search doesn't end here. To really get to know a company, you need to keep digging. If any of the companies I've mentioned here today piques your interest, further examining quality of earnings, management track records, or analyst estimates all make for great ways to continue 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 you can add the stocks mentioned here to My Watchlist.
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