As investors, we always want our investments to generate healthy returns. However, investors often forget that such returns stem from two 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 value investing. In this series, I'll examine both the quality and the pricing of a specific business, to better understand 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 can grow its bottom line faster (sometimes much faster) than the market, especially consistently, obviously gives its owner greater value than a stagnant or declining business. 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.
To evaluate today's stock, I rounded up several ways to measure returns, profitability, growth, and leverage. These represent some of the most important aspects to consider when researching any potential investment.
- Return on equity divides net income by shareholder's equity, highlighting the return a company generates for its equity base.
- The EBIT margin --short for earnings before interest and taxes -- provides a rough measurement of the percentage of operating cash a company manages to keep. I prefer EBIT to other measurements because it focuses more exclusively on the performance of a company's core business. Stripping out interest and taxes makes this figure 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 this figure, the better.
I'm using five-year averages to help smooth away one-year irregularities that could easily distort regular business results. With that in mind, let's look at Corning
Return on Equity
Total Debt / Equity
Source: Capital IQ, a division of Standard &Poor's.
The figures above reveal several impressive performances. Corning generates above-average returns and strong margins, and shows some pretty impressive growth, all while using minimal debt. 3M also generates great returns for its investors, although it seems to lack the same exciting growth prospects as some of its peers. Becton, Dickinson also seems to have its business kicking on all cylinders. While it has the most debt of the companies here, Becton's debt levels of nearly 50% of equity still seem quite reasonable. TE Connectivity, on the other hand, looks like the laggard of the group. While its growth intrigues me, its smaller margins and (especially) returns make it less appealing than some of the other star performers here.
How cheap does Corning look?
To gauge pricing, I studied two important multiples: price to earnings and enterprise value to free cash flow. Like a P/E ratio, the ratio of enterprise value (essentially, debt, preferred stock, and equity holders combined, minus cash) to unlevered free cash flow conveys how expensive the entire company is, relative to the cash it can generate. This gives investors another measurement a stock's cheapness. For both metrics, the lower the multiple, the better.
Let's see what price we'd need to pay to get our hands on some of these companies' earnings:
Enterprise Value / FCF
P / LTM Diluted EPS Before Extra Items
Source: Capital IQ, a Standard &Poor's company.
Corning has the highest EV/FCF ratio, but the lowest P/E. To be fair, this is in large part driven by unlevered cash flow using an EBIT measure that excludes Corning's extremely profitable joint ventures. After considering profits Corning receives from these joint ventures, its cash flows are much more robust. Given their lower historical growth, both 3M and Becton, Dickinson look a little pricey. Especially with its marginal performance, TE Connectivity looks like a company to avoid.
Overall, Corning really impresses me. The underlying business seems like a high-quality one. The company also seems well-positioned to benefit from the increased integration of LCD screens into all kinds of consumer electronics, a trend that should only increase with time.
While Corning's stock certainly looks like a good candidate for your portfolio, your search shouldn't end here. To really get to know a company, you must keep digging. If any of the companies mentioned here today pique your interest, further assessing a company's quality of earnings, management track record, or analyst estimates all make great ways to continue 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.
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Andrew Tonner owns no shares of any of the companies mentioned in this article. Becton and 3M are Motley Fool Inside Value picks. 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.