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 Monsanto
Return on Equity (5-year avg.)
EBIT Margin (5-year avg.)
EBIT Growth (5-year avg.)
Total Debt / Equity
Source: Capital IQ, a Standard & Poor's company.
Monsanto generates pretty average returns on its equity. It produces far and away the stronger EBIT margins of the field with some pretty impressive growth. It maintains the lowest D/E ratio out of this group.
OMNOVA Solutions blows its peers out of the water with its ROE. It has strong growth but quite weak margins. More than anything its capital structure seems slightly alarming. It has more than three times as much debt as equity. This probably accounts for the extremely high relative ROE.
Huntsman stands as the leader of the pack in growth terms. However, it generates a below average ROE and EBIT margin. Especially given its high degree of leverage, this company seems somewhat unappealing as a glance.
Unfortunately, Dow Chemical's ROE, EBIT margin, and growth all look unappetizing. Its capital structure seems reasonable but not devoid of risk.
How cheap does Monsanto 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
Source: Capital IQ, a Standard & Poor's company; NM denotes negative cash flow.
The two companies with multiples for each metric (Monsanto and Dow) look pricey, especially given both of these companies have at least some kind of flaw. OMNIVA looks dirt cheap on an earnings basis, unlike Huntsman. However, both these companies have capital expenditures that erode their entire operating cash flow.
In the final analysis, none of these companies look like stocks worth adding to your portfolio. Especially given each company had some kind of flaw, these prices these firms command don't justify themselves in my mind. Better to sit on the sidelines than overpay for stocks.
While Monsanto's 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.