Has Forest Labs Become the Perfect Stock?

Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?

One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if Forest Labs (NYSE: FRX  ) fits the bill.

The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:

  • Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
  • Margins. Higher sales mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
  • Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
  • Moneymaking opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
  • Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
  • Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.

With those factors in mind, let's take a closer look at Forest Labs.

Factor

What We Want to See

Actual

Pass or Fail?

Growth 5-Year Annual Revenue Growth > 15% 4.2% Fail
  1-Year Revenue Growth > 12% (5.3%) Fail
Margins Gross Margin > 35% 78.5% Pass
  Net Margin > 15% 18.3% Pass
Balance Sheet Debt to Equity < 50% 0% Pass
  Current Ratio > 1.3 4.20 Pass
Opportunities Return on Equity > 15% 14.1% Fail
Valuation Normalized P/E < 20 15.72 Pass
Dividends Current Yield > 2% 0% Fail
  5-Year Dividend Growth > 10% 0% Fail
       
  Total Score   5 out of 10

Source: S&P Capital IQ. Total score = number of passes.

Since we looked at Forest Labs last year, the company lost a point. A significant drop in return on equity led to the score decline, even as the stock managed to eke out about a 10% gain over the past year.

As the maker of the depression drug Lexapro, Forest Labs has been fortunate enough to enjoy blockbuster sales. But with Lexapro's patent having expired earlier this year, the drugmaker is scurrying to find ways to replace the impending loss of revenue as customers move to cheaper generic versions of the drug. Seeing the inevitable, Forest made a deal with generic-maker Mylan (Nasdaq: MYL  ) to give it two weeks of exclusive sales of its new generic. But Teva Pharmaceutical (Nasdaq: TEVA  ) has been waiting to make generic Lexapro ever since it challenged Lexapro's patent back in 2006.

In response, Forest is working to try to bolster its remaining drugs. One success comes from partner Ironwood Pharmaceuticals and its Linzess treatment for irritable bowel syndrome, as Linzess got FDA approval late last month. Now, if Forest can lure millions of patients off Procter & Gamble's (NYSE: PG  ) and Novartis' (NYSE: NVS  ) over-the-counter treatments for the symptoms, it could potentially bring in a lot of cash for the Forest/Ironwood partnership.

Still, some aren't sure about the company's current strategy. Activist investor Carl Icahn has alleged that the company paid its CEO too much and has hidden poison-pill provisions in its licensing agreements. At Forest's annual meeting, Icahn got one seat on Forest's board of directors, but Icahn had been seeking four.

For Forest to improve, it needs to address its patent cliff and try to stoke more revenue from its remaining pipeline. Otherwise, Forest could start looking even less like a perfect stock in the years to come.

Keep searching
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.

Forest Labs may not be perfect, but we've got some other ideas you might like better. Let me invite you to learn about three smart long-term stock plays in the Fool's popular special report. It's yours for the taking and is absolutely free, but don't miss out -- click here and read it today.

Add Forest Labs to My Watchlist, which can find all of our Foolish analysis on it and all your other stocks.

Fool contributor Dan Caplinger doesn't own shares of the companies mentioned. Motley Fool newsletter services have recommended buying shares of Procter & Gamble. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.


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