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 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 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 Kimberly-Clark
Return on Equity (5-year avg.)
EBIT Margin (5-year avg.)
EBIT Growth (5-year avg.)
Total Debt / Equity
Johnson & Johnson
Procter & Gamble
Source: Capital IQ, a Standard &Poor's company.
This graphic demonstrates the value of having strong brand names. Each of these companies owns a portfolio of well-recognized consumer products that consumers frequently reuse. This leads to consistent repeat sales and consistently strong performances. We see a lot of the same dynamics at work with each of these companies. They all generate strong ROEs, although Colgate's 88.3% average ROE blows the field out of the water. The margin front appears pretty impressive as well, although Kimberly-Clark seems much lower at 14.7%. The real story with these businesses largely centers around growth, or lack thereof. While fantastic companies, they need to find ways to increase their presences abroad to keep successfully expanding. In terms of leverage, both Kimberly-Clark and Colgate have higher leverage than I like to see. J&J and Procter & Gamble look much more conservatively financed.
How cheap does Kimberly-Clark 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.
Enterprise Value / FCF
P / LTM Diluted EPS Before Extra Items
|Johnson & Johnson||12.4*||15.2|
|Procter & Gamble||22.7||17.6|
Source: Capital IQ, a Standard & Poor's company; *Uses the most recently available FCF figures (FY '10).
Interestingly enough, some of these companies look pretty attractive given their phenomenal economics. With the lowest margins and growth of the group, Kimberly-Clark still looks slightly overpriced for me. Coming off an extremely trying year, Johnson & Johnson looks somewhat cheap, but less so given its recent rally. Still I think J&J looks attractive at these prices. Similarly, Colgate sits right at that edge of the "expensive but I love the business" threshold. Procter & Gamble looks too expensive for my taste at its current multiples. While I really like all four companies covered here, I only really think two are potential buys in the near term.
While Kimberly-Clark stock doesn't look like a stock for your portfolio right now, 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.
Andrew Tonner holds no position in any of the companies mentioned in this article. The Fool owns shares of Johnson & Johnson. Motley Fool newsletter services have recommended Johnson & Johnson, Kimberly Clark, and Procter & Gamble. Motley Fool newsletter services have recommended creating a diagonal call position in Johnson & Johnson.
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