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:

1) The business's ability to generate profits.
2) 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 Alliant Techsystems (NYSE: ATK) and some of its closest peers.

Company Name

Return on Equity (5-year avg.)

EBIT Margin (5-year avg.)

EBIT Growth (5-year avg.)

Total Debt / Equity

Alliant Techsystems 30.40% 10.67% 10.37% 138.04%
Northrop Grumman (NYSE: NOC) 7.69% 8.56% 7.74% 31.38%
General Dynamics (NYSE: GD) 20.57% 11.69% 12.87% 23.08%
Raytheon (NYSE: RTN) 15.96% 10.96% 10.85% 35.92%

Source: Capital IQ, a Standard & Poor's company.

These figures looks typical of those in the defense industry (note the similarity from company to company). Alliant Techsystems produces the strongest ROE out of the group, although it also employs by far the most leverage out of its peer group. It generates low EBIT margins. It has expanded its business at a respectable but not break-neck rate.

Northrop looks like the weakest out of the group. It has the lowest ROE, EBIT margin, and growth figures of the group. However, it could expect some tailwinds with its recent spin-off of its barely profitable ship building unit.

General Dynamics and Raytheon look like very similar on paper. They both produce near average ROE figures, with respectable EBIT margins and growth. They also have conservative capital structures as well.

How cheap does Alliant 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.

Company

Enterprise Value / FCF

P / LTM diluted EPS before Extra Items

Alliant Techsystems 11.54 7.81
Northrop Grumman 9.04 9.07
General Dynamics 10.20 10.55
Raytheon 13.61 10.77

Source: Capital IQ, a Standard & Poor's company.

Things get quite interesting in assessing the price-value proposition of defense contractors, as I've written about several times. These firms all look cheap on paper. However, many market participants will disagree with me, saying the defense industry as a whole should suffer. While difficult to refute on the whole, I ran the numbers and think people have overreacted somewhat.

These companies could all make for buys in your portfolio. The key to investing in any of these firms lies in your opinion of defense spending going forward. If you think investors have it wrong, defense stocks could make for a set of quality, established businesses to scoop up on the cheap, just make sure you fully understand the risks before acting.

While Alliant Techsystems could be 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 Motley Fool owns shares of Northrop Grumman, General Dynamics, and Raytheon. 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.