How Reasonable Is Varian's Stock by the Numbers?

Numbers can lie -- but they're the best first step in determining whether a stock is a buy. In this series, we use some carefully chosen metrics to size up a stock's true value based on the following clues:

  • The current price multiples.
  • The consistency of past earnings and cash flow.
  • How much growth we can expect.

Let's see what those numbers can tell us about how expensive or cheap Varian Medical Systems (NYSE: VAR  ) might be.

The current price multiples
First, we'll look at most investors' favorite metric: the P/E ratio. It divides the company's share price by its earnings per share (EPS) -- the lower, the better.

Then, we'll take things up a notch with a more advanced metric: enterprise value to unlevered free cash flow. This divides the company's enterprise value (basically, its market cap plus its debt, minus its cash) by its unlevered free cash flow (its free cash flow, adding back the interest payments on its debt). Like the P/E, the lower this number is, the better.

Analysts argue about which is more important -- earnings or cash flow. Who cares? A good buy ideally has low multiples on both.

Varian has a P/E ratio of 19.1 and an EV/FCF ratio of 21.2 over the trailing 12 months. If we stretch and compare current valuations to the five-year averages for earnings and free cash flow, Varian has a P/E ratio of 22.9 and a five-year EV/FCF ratio of 22.8.

A positive one-year ratio under 10 for both metrics is ideal (at least in my opinion). For a five-year metric, under 20 is ideal.

Varian is 0 for 4 on hitting the ideal targets, but let's see how it compares against some competitors and industry mates. 

Company

1-Year P/E

1-Year EV/FCF

5-Year P/E

5-Year EV/FCF

Varian 19.1 21.2 22.9 22.8
PerkinElmer 458.0 18.4 20.8 22.6
Life Technologies 19.8 12.4 38.6 17.8
Hill-Rom Holdings 16.8 10.9 78.2 14.6

Source: S&P Capital IQ; NM = not meaningful due to losses.

Numerically, we've seen how Varian's valuation rates on both an absolute and relative basis. Next, let's examine …

The consistency of past earnings and cash flow
An ideal company will be consistently strong in its earnings and cash flow generation.

In the past five years, Varian's net income margin has ranged from 13.5% to 15.8%. In that same time frame, unlevered free cash flow margin has ranged from 12.0% to 16.2%.

How do those figures compare with those of the company's peers? See for yourself:

Source: S&P Capital IQ; margin ranges are combined.

Additionally, over the last five years, Varian has tallied up five years of positive earnings and five years of positive free cash flow.

Next, let's figure out …

How much growth we can expect
Analysts tend to comically overstate their five-year growth estimates. If you accept them at face value, you will overpay for stocks.  But while you should definitely take the analysts' prognostications with a grain of salt, they can still provide a useful starting point when compared to similar numbers from a company's closest rivals.

Let's start by seeing what this company's done over the past five years. In that time period, Varian has put up past EPS growth rates of 12.9%. Meanwhile, Wall Street's analysts expect future growth rates of 13.0%.

Here's how Varian compares to its peers for trailing five-year growth:

Source: S&P Capital IQ; EPS growth shown.

And here's how it measures up with regard to the growth analysts expect over the next five years:

Source: S&P Capital IQ; estimates for EPS growth.

The bottom line
The pile of numbers we've plowed through has shown us the price multiples shares of Varian are trading at, the volatility of its operational performance, and what kind of growth profile it has -- both on an absolute and a relative basis.

The more consistent a company's performance has been and the more growth we can expect, the more we should be willing to pay. We've gone well beyond looking at a 19.1 P/E ratio and we see slightly premium price multiples all around. But we also see solid numbers all around. Its margins have been consistent and strong versus its peers. It's also shown some good earnings growth over the last five years.

As another data point, our CAPS community rates Varian four stars (out of five). The initial numbers are both pricey and promising, but all this is just a start. If you find Varian's numbers or story compelling, don't stop. Continue your due diligence process until you're confident one way or the other. As a start, add it to MyWatchlist to find all of our Foolish analysis.

I wrote about a stock that's flying under the radar in our brand new free report: "The Stocks Only the Smartest Investors Are Buying." I invite you to take a free copy to find out the name of the company I believe Warren Buffett would be interested in if he could still invest in small companies.

Anand Chokkavelu doesn't own shares in any company mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On February 27, 2012, at 8:38 PM, IPHedge wrote:

    Interesting article but have you considered the impact of the $37 M jury damage verdict which may be tripled by the judge ? University of Pittsburgh sued Varian for patent infringement and last week a jury awarded $37 M as damages and found infringement to be willful. So the judge can increase the damages to over $100 M. In addition, Varian will have to pay a royalty going forward and the royalty could be steep. I bought puts on Varian after learning of this development.

    IPHedge

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