Numbers can lie -- yet they're the best first step in determining whether a stock is a buy. In this series, we use some carefully chosen metrics to size up a stock's true value based on the following clues:
- The current price multiples.
- The consistency of past earnings and cash flow.
- How much growth we can expect.
Let's see what those numbers can tell us about how expensive or cheap Varian Medical Systems
The current price multiples
First, we'll look at most investors' favorite metric: the P/E ratio. It divides the company's share price by its earnings per share (EPS) -- the lower, the better.
Then we'll take things up a notch with a more advanced metric: enterprise value to unlevered free cash flow, which divides the company's enterprise value (basically, its market cap plus its debt, minus its cash) by its unlevered free cash flow (its free cash flow, adding back the interest payments on its debt). As with the P/E, the lower this number is, the better.
Analysts argue about which is more important -- earnings or cash flow. Who cares? A good buy ideally has low multiples on both.
Varian has a P/E ratio of 19.6 and an EV/FCF ratio of 18.4 over the trailing 12 months. If we stretch and compare current valuations with the five-year averages for earnings and free cash flow, we see that we see that Varian has a P/E ratio of 24.4 and a five-year EV/FCF ratio of 23.5.
A positive one-year ratio of less than 10 for both metrics is ideal (at least in my opinion). For a five-year metric, less than 20 is ideal.
Varian is 0-for-4 on hitting the ideal targets, but let's see how it stacks up against some of its competitors and industry mates.
Source: S&P Capital IQ; NM = not meaningful because of losses.
Numerically, we've seen how Varian's valuation rates on both an absolute and relative basis. Next, let's examine ...
The consistency of past earnings and cash flow
An ideal company will be consistently strong in its earnings and cash-flow generation.
In the past five years, Varian's net income margin has ranged from 13.5% to 15.4%. In that same time frame, unlevered free cash flow margin has ranged from 11% to 16.8%.
How do those figures compare with those of the company's peers? See for yourself:
Source: S&P Capital IQ; margin ranges are combined.
In addition, over the past five years, Varian has tallied up five years of positive earnings and five years of positive free cash flow.
Next, let's figure out ...
How much growth we can expect
Analysts tend to comically overstate their five-year growth estimates. If you accept them at face value, you will overpay for stocks. But even though you should definitely take the analysts' prognostications with a grain of salt, they can still provide a useful starting point when compared with similar numbers from a company's closest rivals.
Let's start by seeing what this company's done over the past five years. In that time period, Varian has put up past EPS growth rates of 13.8%. Meanwhile, Wall Street's analysts expect future growth rates of 13.1%.
Here's how Varian compares with its peers for trailing-five-year growth:
Source: S&P Capital IQ; EPS growth shown.
And here's how it measures up with regard to the growth analysts expect over the next five years:
Source: S&P Capital IQ; estimates for EPS growth.
The bottom line
The pile of numbers we've plowed through has shown us the price multiples that shares of Varian are trading at, the volatility of its operational performance, and what kind of growth profile it has -- both on an absolute and a relative basis.
The more consistent a company's performance has been and the more growth we can expect, the more we should be willing to pay. We've gone well beyond looking at a 19.6 P/E ratio, and we see moderate price multiples all around. Depending on which metric you look at, Varian is either middle of the pack or expensive versus its peers.
However, where it shines is in the quality and consistency of its prior earnings and free cash flows. It blows PerkinElmer, Life Technologies, and Hill-Rom out of the water here. Meanwhile, all four have had good past growth in the past five years.
Our CAPS community rates Varian five stars out of five, which is also a good sign. But these initial numbers are just a start. If you find Varian's numbers or story compelling, don't stop here. Continue your due-diligence process until you're confident one way or the other. Remember to keep tabs on any effects of health-care regulation as well. As a start, add it to My Watchlist to find all of our Foolish analysis.
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Anand Chokkavelu doesn't own shares in any company mentioned. 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.