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 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 Eli Lilly (NYSE: LLY) and some of its closest peers.

Company

Return on Equity (5-Year Avg.)

EBIT Margin (5-Year Avg.)

EBIT Growth (5-Year Avg.)

Total Debt / Equity

Eli Lilly 25.58% 27.60% 13.23% 47.88%
GlaxoSmithKline (NYSE: GSK) 49.49% 33.84% 5.75% 152.59%
Pfizer (NYSE: PFE) 12.44% 31.05% 4.56% 45.74%
Teva (Nasdaq: TEVA) 10.64% 25.45% 28.95% 29.20%

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

Biotech companies can put up some pretty impressive figures, something we certainly see at work here. Eli Lilly generates above-average returns on its equity, operating margins, and growth. It accomplished all this while maintaining a safe capital structure.

Similarly, GlaxoSmithKline blows the rest of the field out of the water with its ROE. It also generates the highest relative operating margin, but not to the same extent as its return on equity. Two red flags do appear regarding its growth (somewhat weak) and its financing (by far the most leveraged).

Pfizer's return on equity appears paltry compared to its peers above. Its healthy operating margin and capital structure do seem like plusses for Pfizer, though. However, its growth seems to have slowed over the past five years, a topic of anxiety for its investors.

Teva produced the lowest returns on equity and EBIT margins for its stockholders among this set of companies. On the other hand, it created far and away the greatest levels of growth. It also has the most conservative financing arrangements, carrying little debt on its balance sheet.

How cheap does Eli Lilly 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

Eli Lilly 6.93 8.73
GlaxoSmithKline 16.23 37.07
Pfizer 8.60 19.49
Teva 14.81 13.22

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

Rather than looking back at their past performance, Mr. Market seems predominantly focused on key patent expirations looming over Eli Lilly and Pfizer in the coming years. A lot of that misery seems priced into the stocks at present, making them look extremely cheap at the moment. However, if key patents expire without the genesis of newer patents, expect earnings to take a major hit. With its high ROE and margins, Glaxo looks somewhat expensive, especially without a really compelling history of growth. Teva looks by far the cheapest, especially considering its gaudy growth rates.

In looking at these companies, I don't necessarily see any one stock that seems either deserving of a premium or cheap enough to seem tempting. I think passing here makes the most sense for conservative investors.

While Eli Lilly 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 Motley Fool CAPS, 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 Teva Pharmaceutical Industries and GlaxoSmithKline. Motley Fool newsletter services have recommended buying shares of Teva Pharmaceutical Industries, Pfizer, and GlaxoSmithKline. 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.