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 SandRidge Energy
| Company | ROE (5-year avg.) | EBIT Margin (5-year avg.) | EBIT Growth (5-year avg.) | Total Debt/Equity (%) |
|---|---|---|---|---|
| SandRidge Energy | (131%) | (67.9%) | 183.1% | 161.9% |
|
Denbury Resources |
14.2% | 34.2% | 38.2% | 49.4% |
|
Kinder Morgan Energy Partners |
19.2% | 16.3% | 10.0% | 157.5% |
|
Chesapeake Energy |
2.6% | 35.2% | 21.1% | 65.3% |
Source: Capital IQ, a division of Standard &Poor’s.
The performances displayed here range from quite impressive to somewhat alarming. SandRidge had substantially negative past ROEs and operating margins. However, it also managed to grow its operating earnings at a breakneck average annual rate during this time frame. Denbury and Kinder Morgan both produced average returns. Chesapeake and Denbury both also put up impressive growth figures, while also maintaining attractive operating margins as well. Debt looks like a possible issue for SandRidge and Kinder Morgan. Make sure to keep your eyes on that.
How cheap does SandRidge Energy 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.
| Company | EV/FCF | P/LTM Diluted EPS Before Extra Items |
|---|---|---|
| SandRidge Energy | (5.5) | NM |
| Denbury Resources | (54.5) | 20.5 |
| Kinder Morgan Energy Partners | 22.4 | 117.7 |
| Chesapeake Energy | (3.2) | 20.1 |
Source: Capital IQ, a division of Standard &Poor’s. NM = not meaningful.
On the pricing front, the trading multiples look pretty unattractive. Only Kinder Morgan managed to produce any free cash flow over the last 12 months. However, its price-to-earnings multiple sitting near 120 times looks unattractively high as well. These don’t look like obvious bargains.
Overall, I don’t really like what I see on the surface. The companies here have some impressive qualities. However, they lack the consistency I prefer to find in my investments. Better to wait patiently for an enticing opportunity than to risk your hard-earned money.
While SandRidge Energy 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, 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.
