Does Xerox Deserve a Spot in Your Portfolio?

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 Xerox (NYSE: XRX) and some of its closest peers. 

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

We see all kinds of varying performances among these companies. Xerox looks decidedly underwhelming, with its historical ROE and operating margin sitting well below average. On the other hand, I like its double-digit growth and relatively conservative debt load.

Pitney Bowes generates a huge return on its equity base and also has the strongest EBIT margin out of the pack, but it appears that the company leveraged itself to the hilt to generate those outsized returns, certainly a red flag to even a semi-conservative investor. That red flag probably becomes even more significant when considering that the company's earnings shrank during this same five-year period. If that dynamic becomes a larger trend, it could make for a quite a deadly combination.

Clearly looking like the weakest out of the group, Electronics for Imaging had negative figures for all three key metrics over the past half-decade. That almost certainly makes it a no-go for our purposes.

Lexmark generates an impressive return on its equity. Although its margins and growth don't look extraordinary, they don't fall flat on their face, either. I like its conservative capital structure.

How cheap does Xerox 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.

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

Things become more intriguing when looking at these companies from a pricing perspective. Both Xerox and Pitney Bowes look cheap. Given its weak performance, Electronics for Imaging's high multiples make it a stock to skip. Lexmark, meanwhile, looks extremely cheap relative to its past performance.

In the end, we see a few stocks that probably deserve further research -- Xerox, Pitney Bowes, and Lexmark.

Although Xerox stock could possibly become 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.