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 Allegheny Technologies
|
Company |
Return on Equity (5-year avg.) |
EBIT Margin (5-year avg.) |
EBIT Growth (5-year avg.) |
Total Debt / Equity |
|---|---|---|---|---|
|
Allegheny Technologies |
24.57% |
12.67% |
30.42% |
70.90% |
|
Alcoa |
6.86% |
7.05% |
13.33% |
50.50% |
|
Century Aluminum |
(36.79%) |
8.63% |
42.86% |
25.90% |
|
Freeport-McMoRan |
21.45% |
42.56% |
44.91% |
29.53% |
Source: Capital IQ, a Standard & Poor's company.
Allegheny produces the strongest ROE of the bunch with strong margins and especially growth fueling the overall performance. It does have the highest debt load among these companies.
Alcoa looks pretty unappealing. It generates a meager return on its equity with the weakest operating margin and growth of the group. However, it seems to have its capital structure in order.
With a powerfully negative ROE figure over the last five years, Century Aluminum also looks like a weak option. Despite its strong growth, it has unattractive margins. Its debt-to-equity ratio holds the top spot among its peers, though. The company looks financially safe.
Freeport-McMoRan looks like the clear leader out of this set of companies. It tallies above-average results in all four key metrics tested here.
How cheap does Allegheny Technologies 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 |
|---|---|---|
|
Allegheny Technologies |
NM |
59.57 |
|
Alcoa |
35.51 |
22.73 |
|
Century Aluminum |
19.96 |
20.01 |
|
Freeport-McMoRan |
9.81 |
9.72 |
Source: Capital IQ, a Standard & Poor's company; NM = not meaningful, denoting a negative figure.
From a pricing perspective, Allegheny, Alcoa, and Century all look expensive. On the other hand, Freeport does look attractively priced with both key pricing multiples sitting below 10.
Out of this group of companies, Freeport looks like the only one deserving of further investigation. Both its business results and pricing look pretty favorable to me.
While Allegheny Technologies 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.
