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's 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. In doing so, hopefully 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 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 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 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, but, generally speaking, 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 Amgen (Nasdaq: AMGN ) 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
|
| Amgen |
18.72% |
37.16% |
2.99% |
43.66% |
| Biogen Idec (Nasdaq: BIIB ) |
11.52% |
29.64% |
35.82% |
21.15% |
| Celgene (Nasdaq: CELG ) |
0.58% |
25.24% |
88.06% |
21.22% |
| Gilead Sciences (Nasdaq: GILD ) |
30.25% |
51.80% |
30.34% |
72.92% |
Source: Capital IQ, a Standard &Poor's company.
Biotech firms can generate some pretty gaudy figures, as seen above. Amgen's margins look like its strongest point. It also generates an average return on equity. Its growth looks like a concern, lagging the competition by a massive margin. It has reasonable financing.
Biogen Idec also shows pretty weak margins. However, the strength of its margins and growth indicate future returns might become better than those of the past five years. It has a conservative capital structure, little financial risk here.
Celgene has generated essentially zero return for its equity holders over the past half-decade. Most of this owes to a single asset writedown in 2008 overshadowing other profitable years. It generates a healthy EBIT margin. Its growth really sets it apart from the pack, though, more than twice as much as its peer group. Like Biogen, it has very conservative financing at present.
Gilead Sciences looks like the top performer among the group. Over the past five years, it generated the greatest ROE and EBIT margin. While not the top grower, its 30% growth still seems compelling. While probably not in the worrisome range, it has the most aggressive capital structure.
How cheap does Amgen 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
|
| Amgen |
9.80 |
12.65 |
| Biogen Idec |
17.10 |
22.29 |
| Celgene |
25.08 |
31.50 |
| Gilead Sciences |
11.64 |
12.84 |
Source: Capital IQ, a Standard &Poor's company.
Amgen looks by far the most cheaply priced, probably because of its weak growth. Always skeptical of paying up for future earnings, both Biogen and Celgene look too expensive for my blood. Gilead clearly looks like the best bargain among these four.
Depending on your assessment of future growth, Amgen could certainly make a nice addition to your portfolio. However, if you prefer to take part in the next big thing, Amgen might not have your name written on it.
While Amgen looks like a possible stock for your portfolio right now (depending on your style), 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 pique 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 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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