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' 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 approach known as value investing. In this series, I'll examine a specific business from both a quality and pricing standpoint. In doing so, I hope to provide 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 varies 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. 

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 percentage of cash a company keeps from its operations. I prefer using EBIT over 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 all that in mind, let's take a look at Weyerhaeuser (NYSE: WY) and some of its closest peers. 

Company

Return on Equity (5-Year Average)

EBIT Margin (5-Year Average)

EBIT Growth (5-Year Average)

Total Debt / Equity

Weyerhaeuser (1.50%) 2.24% (52.41%) 107.53%
Temple-Inland (NYSE: TIN) 27.00% 5.72% 26.33% 73.31%
Mercer International (Nasdaq: MERC)

0.61%

 

7.68%

 

1,819.57%

 

314.47%

 

International Paper (NYSE: IP) 6.75% 6.87% 12.44% 112.71%

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

These performances largely leave something to be desired. Weyerhaeuser generated a negative average return on its equity over the past five years, and its substandard margin and negative growth also speak to the lackluster performance over that period. Its capital structure looks risky as well.

Temple Island looks like the strongest company out of the bunch. It produced an above-average ROE , reasonably small margins, and strong growth on average over the past five years. It also has the most conservative financing out of the bunch, certainly a plus.

Mercer International looks a lot like Weyerhaeuser, apart from its growth. It produced weak returns on equity and small margins (although the largest of this bunch). The company did manage to achieve breakneck growth rates during this period, though that was a result of past struggles that made recent results impressive by comparison. The company also has by far the riskiest capital structure of the group, a red flag in my book.

International Paper looks below average in every regard except for its growth. Its single-digit average ROE and operating margin do little for me as an investor. It does have respectable, if not spectacular, growth, but its capital structure looks pretty risky.

How cheap does Weyerhaeuser look?
To look at pricing, I've chosen to examine 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. The resulting figure 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

Weyerhaeuser 84.44 6.36
Temple-Inland 103.59 13.45
Mercer International 8.78 4.52
International Paper 17.49 12.15

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

The only company that looks extremely attractive from a pricing standpoint is Mercer International. Weyerhaeuser, Temple-Inland, and International Paper all have appealing multiples on one of the two key metrics examined here, and with low figures for both, Mercer International takes the cake from a multiples standpoint.

In the end, the only really compelling opportunity looks like Mercer International.

Although Weyerhaeuser stock doesn't look like a stock for your portfolio right now, the search doesn't end here. To really get to know a company, you need to keep digging. If any of the companies I've mentioned here today piques your interest, further examining quality of earnings, management track records, or analyst estimates all make for great ways to continue 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 you can add the stocks mentioned here to My Watchlist.

Andrew Tonner holds no position in any of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.