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-to-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 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 Star Scientific
Return on Equity (5-year avg.)
EBIT Margin (5-year avg.)
EBIT Growth (5-year avg.)
Total Debt / Equity
Source: Capital IQ, a Standard & Poor's company. NM appears because of negative book value.
With its key products still in the development phase, it makes sense that the company currently generates no profits. In keeping with the history of impressive returns for the industry, the more established players generate some impressive returns. Altria generates above average returns and margins, although I dislike their leverage and poor past growth. Lorillard similarly mints money for its owners, putting up robust figures in each category. Lagging Altria and Lorillard, Reynolds seems highly lucrative with reasonable debt levels as well.
How cheap does Star Scientific 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.
Enterprise Value / FCF
P / LTM diluted EPS before Extra Items
Source: Capital IQ, a Standard &Poor's company.
Again Star Scientific's newness bears out in these figures. On a price-to-earnings basis, Altria, Lorillard, and Reynolds American all trade at a discount to the market. However, this kind of pricing doesn't look like a fire sale to me either, given their lack of significant recent growth. Altria and Reynolds both look pricier considering their high EV-to-cash flow multiples. Overall, Lorillard looks like the cheapest out of the bunch.
While they share the same industry, these numbers demonstrate that Star Scientific has quite a ways to go before it competes with the major players in the tobacco industry. In my mind, its lack of a proven track record makes it a stock to avoid at the moment. However, with its potentially game-changing products, Star Scientific could pose a genuine threat to the big boys sooner rather than later.
While Star Scientific's stock 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, 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 page where our users come to share their ideas and chat about their favorite stocks or click HERE to add them to My Watchlist.
Andrew Tonner holds no position in any of the companies mentioned in this article. Motley Fool Options has recommended writing puts on Lorillard. The Fool owns shares of Altria Group. 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.