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 United Parcel Service (NYSE: UPS) 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

United Parcel Service 26.89% 12.06% 2.00% 146.85%
Xerox (NYSE: XRX) 9.82% 8.42% 10.40% 71.17%
R.R. Donnelley & Sons (Nasdaq: RRD) 2.43% 8.92% (1.72%) 155.83%
Pitney Bowes (NYSE: PBI) 106.31% 16.80% (4.43%) 1578.40%

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

The performances here run all over the spectrum. Over the last five years, UPS produced an above-average ROE. But couple that with a decent, but not robust, operating margin and pretty meager growth, and the company looks quite average. It also has some legitimate financial risk, with its D/E ratio sitting well above the 1-to-1 ceiling I like for most businesses.

Xerox appears to have a slightly different set of strengths versus UPS. It generates a historical return on its equity well below the S&P 500 average, with weaker EBIT margins as well. However, it demonstrates the greatest ability among this group of companies to grow its operations. It's also the only company here that has what I'd call a "safe" capital structure (debt-to-equity < 100%).

R.R. Donnelley & Sons put forth the worst overall performance. It appears the company struggled in a number of ways. Not only did it turn in historical ROEs and operating margins well below the norm, but it also sports negative growth and a heavy debt burden. This company has a number of issues working against it.

Pitney Bowes shows some signs of life. Although a triple-digit historical return on equity looks impressive, the company's extreme leverage certainly helped it generate such a lofty figure. It does have the strongest operating margin out of the group, but its negative growth gives me additional cause for concern. This company looks leveraged to the hilt, too, so approach with caution.

How cheap does United Parcel Service 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

United Parcel Service 38.21 19.05
Xerox 11.70 15.72
R.R. Donnelley & Sons 17.26 21.55
Pitney Bowes 10.65 15.53

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

From a multiples perspective, nothing here looks singularly cheap. In terms of the cash-flow multiples, Xerox and Pitney look attractively priced. However, no company appears to be a real bargain from an earnings standpoint.

In the end, none of these companies has a favorable enough risk-reward proposition to really deserve a strong second look. As a more conservative investor by nature, I think waiting to find an investment scenario where the odds lie strongly in your favor is best way to deploy your hard-earned savings.

Although UPS 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. The Motley Fool owns shares of UPS 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.