On paper, investing in the healthcare sector might look like a no-brainer.
Biotechnology stocks have vastly outperformed the broader market since the March 2009 bottom. More recently, Receptos and bluebird bio have risen by better than 1,000% and 600%, respectively, while the now-private Pharmacyclics managed a breathtaking 45,700% run between its bottom of $0.57 and its last trade north of $261 in a span of five years.
But there's more to the healthcare sector than throwing darts and getting lucky once in a while. Even though healthcare -- more than any other sector -- allows Wall Street and investors to value a company based on the peak sales potential of a product, device, diagnostic tool, or service, a few underlying financial metrics of a company are always important.
Financial statement analysis: three metrics you need to know
Today, I'll explain three figures on a financial statement analysis that all investors should be eyeing when researching healthcare stocks. Whether you're looking at a clinical-stage biotech company or a Big Pharma giant, these three metrics should matter to you.
1. Cash and cash equivalents
The healthcare space is in many ways similar to the industrials sector. Creating a diverse and profitable product portfolio can be extremely capital intensive. Whether a company is developing diagnostic tests or the next cancer drug, the costs to create those products put a good number of companies in the loss column. Of the 633 healthcare companies with a market cap above $50 million as of Friday's close, just 219 were profitable on a trailing basis per Finviz, and some were only profitable due to a one-time licensing payment, divestment, or other one-time benefit. The lesson here is that most healthcare companies lose money.
Therefore, the one figure that's paramount when conducting a financial statement analysis of healthcare stocks is a company's cash on hand and cash equivalents. This would include cash as well as money received that's yet to be deposited, savings accounts, money market accounts, and any short-term, highly liquid investments.
The reason this figure is so important is that you want to know if a company you own or are considering buying has enough cash on hand to keep its operations going.
As an example, I own shares of Exelixis (NASDAQ:EXEL). Its recent data has been very positive; however, it only has enough cash and cash equivalents available, by my estimates, to keep its operations going for another three or four quarters. This means that a potentially dilutive share offering could soon be in the works, or perhaps Exelixis will have to find a licensing partner for certain therapies in its product portfolio.
In short, understanding the cash capabilities of a healthcare stock is very important.
2. Free cash flow
Once you have a good grasp of how much cash a company has on hand, the next metric to examine during your financial statement analysis is its free cash flow, or FCF.
Why free cash flow? The answer is we want to know not only how much cash our company has on hand, but whether that cash is increasing or decreasing. For instance, a company can be generating positive FCF, but may ultimately report a net loss. This isn't as common in healthcare as other sectors, but it can happen. Non-cash charges such as depreciation or the write-off of bad debt can lead to red ink in the income column, but not actual cash outflows for the company. In other words, FCF helps us determine whether or not a company can meet its expense obligations.
Take ZELTIQ Aesthetics (NASDAQ:ZLTQ) as an example. ZELTIQ, which makes the revolutionary CoolSculpting system that allows fat cells to be frozen and removed from the body over the course of a few weeks, is only projected to earn about $0.03 in EPS this year. The company is in the process of turning the corner to profitability, which could cause some investors to question its valuation or even cash position, especially if red ink shows up in the income column as it did during the first quarter. However, from a cash flow basis Wall Street estimates ZELTIQ will earn $0.36 per share this year, implying that it's having no problem meeting its expenses and is actually investing heavily back into its business.
FCF can often teach you a lot more about a healthcare stock than simply examining its profits or losses for the quarter or year.
3. Operating expenses
Lastly -- and you'll note we're almost building a story here, since one metric tends to builds off the last metric -- you'll want to pay close attention to a healthcare company's operating expenses during your financial statement analysis.
There are generally two categories that make up the bulk of operating expenses for a healthcare company: research and development costs, and selling, general, and administrative expenses, known also as SG&A. Research and development comprises exactly what it sounds like: the cost to develop new drugs, devices, and diagnostic tests and test them in a clinical setting. Generally speaking, the later into the development process a product or drug goes, the more expensive it becomes as the trial encompasses a growing number of test subjects. SG&A expenses include things like wages and marketing costs for a company.
Healthcare investors will want to keep an eye on a company's operating expenses since these expenses can often tell you whether a company is on the offensive or defensive. You'll typically see costs rising when a health care company has a number of compounds in clinical development, or when those compounds hit mid- or late-stage trials. These rising expenses are often welcome by investors, because they mean a catalyst is around the corner. The danger of rising expenses, of course, is that if those trials don't meet their endpoint, cash on hand may become a concern.
Conversely, falling operating expenses can be both good and bad. Expenses may fall simply because a trial run in the prior year is no longer being run this year, or because of improved operating efficiencies. This was would be viewed positively by investors. On the other hand, falling expenses with falling revenue could be a worrisome combination.
For example, Big Pharma giant Pfizer (NYSE:PFE)
Do you have a favorite financial metric for healthcare companies that I've missed? Sound off in the comments section.
Sean Williams owns shares of Exelixis, but has no material interest in any other companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
The Motley Fool owns shares of, and recommends Apple. It also recommends Bluebird Bio, Exelixis, and Zeltiq Aesthetics. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.