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, and
- 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 Stewart Enterprises
Return on Equity (5-year avg.)
EBIT Margin (5-year avg.)
EBIT Growth (5-year avg.)
Total Debt / Equity
Service Corp. International
Source: Capital IQ, a Standard & Poor's company.
Stewart Enterprises produces a below average return on equity. Couple that with its average margin and slow shrinking EBIT, and the actual business seems pretty unremarkable. Its capital structure seems reasonable enough.
Stonemor Partners generates essentially no ROE and has seen EBIT shrink even faster -- not a pretty picture. It also generates the lowest EBIT margin out of the group. Although the most conservatively financed, the actual business itself looks weak.
Service Corp. International at least generates positive figures in all the business categories viewed here. It also stands alone as the only firm here to expand its business over the past five years -- a definite plus -- and has the most leverage among its peers. While not a home run by any stretch of the imagination, Service Corp. International does have a few bright spots working in its favor.
Hillenbrand looks like the strongest firm here. Without significantly over-leveraging itself, it manages to generate quite impressive returns on equity and EBIT margins. While certainly lacking a growth component, at least Hillenbrand has a strong core business at present.
How cheap does Stewart 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
|Service Corp. International||17.74||21.32|
Source: Capital IQ, a Standard & Poor's company; NM denotes losses or negative free cash flow.
None of these companies look like absolute steals -- not by a long shot. Given they all have some kind of flaw within their business, they all look pretty unappealing when analyzing them from a pricing standpoint. Although certainly biased towards value stocks, these companies seem difficult to rationalize as investments under any scenario.
I think passing on each of these stocks seems like the only wise move at present. If something changes in the risk-reward proposition, perhaps they could then become buys. However, they'll have to get significantly cheaper or bolster their operations in order to seem appealing to me.
While Stewart Enterprises 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 Motley Fool owns shares of Hillenbrand. Motley Fool newsletter services have recommended buying shares of Hillenbrand. 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.