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 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/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 Agrium
|
Company Name |
Return on Equity (5-year avg.) |
EBIT Margin (5-year avg.) |
EBIT Growth (5-year avg.) |
Total Debt / Equity |
|---|---|---|---|---|
|
Agrium |
16.39% |
10.21% |
0.00% |
61.18% |
|
CF Industries |
31.41% |
22.37% |
161.03% |
30.35% |
|
PotashCorp |
32.24% |
32.64% |
71.14% |
61.37% |
|
Chemical & Mining Company of Chile |
22.69% |
27.48% |
34.67% |
70.71% |
Source: Capital IQ, a Standard & Poor's company.
The fertilizers and agricultural chemicals industry has been absolutely on fire of late, especially the bottom three companies in the chart. We see above average returns on equity across the board with CF Industries and Potash leading the pack here. CF industries, PotashCorp, and Chemical & Mining Company of Chile all exhibit outstanding growth and operating margins. These companies all have healthy capital structures.
How cheap does Agrium 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 |
|---|---|---|
|
Agrium |
(106.83) |
11.27 |
|
CF Industries |
6.93 |
11.67 |
|
PotashCorp |
48.26 |
18.45 |
|
Chemical & Mining Company of Chile |
50.63 |
36.91 |
Source: Capital IQ, a Standard & Poor's company.
Both Agrium and PotashCorp look quite cheap judged by their earnings alone, but Agrium's cash flow multiple sits squarely in the red due to substantial capital expenditures. CF Industries looks like the cheapest stock on paper. Both PotashCorp and Chemical & Mining Company of Chile look priced for their extravagant growth.
On this surface analysis, CF Industries clearly looks like the most attractive candidate for your portfolio. Agrium's heavy capex, not necessarily a negative, will require further investigation to really form a comprehensive opinion. PotashCorp and Chemical & Mining Company of Chile appear too pricey for my taste.
While Agrium stock at first 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, then 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 community where our users come to share their ideas and chat about their favorite stocks or click here to add them to My Watchlist.
