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's 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 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 owners 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 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 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 lululemon athletica (Nasdaq: LULU) and some of its closest peers.

Company

Return on Equity
(5-Year Avg.)

EBIT Margin
(5-Year Avg.)

EBIT Growth
(5-Year Avg.)

Total Debt / Equity

lululemon athletica 33.3% 19.5% 66.2% 0.0%
Nike (NYSE: NKE) 22.0% 13.2% 5.7% 6.2%
Polo Ralph Lauren (NYSE: RL) 17.2% 14.2% 12.7% 8.1%
Under Armour (NYSE: UA) 16.6% 11.7% 28.5% 2.6%

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

Many of these companies show strong fundamentals. More than anything, lululemon's amazing past growth really impresses me. It also generates high returns and margins, all without the use of debt. Nike, the preeminent giant in the athletic apparel industry, shows why it deserves such a high spot in its industry. It generates robust returns, with healthy margins and growth using little leverage.

Similarly, Ralph Lauren generates solid returns, margins, and some impressive growth with minimal debt. Newer to the scene, Under Armour's best characteristic is its growth. It also produces nice returns with some lower-than-ideal margins and no debt. lululemon looks like the clear leader of the pack, but as we'll see below, the business results present only half of the investing equation.

How cheap does lululemon athletica 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

lululemon athletica 44.9 58.4
Nike 12.0 19.0
Polo Ralph Lauren 16.5 21.4
Under Armour 175.5 48.8

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

lululemon looks extremely expensive, demonstrating the all-too-often practice of investors' paying a stiff premium for future growth. Nike looks a little cheap here, especially on a cash flow basis. Although the second-cheapest, Ralph Lauren looks a little pricy for my taste, probably a reflection of investors again paying more for better growth prospects. Under Armour's pricing surprised me. As we should expect for a company with a near-30% growth rate, it looks expensive. However, it looks like the company generates almost no operating cash flow, and not because of heavy capital expenditures either (a red flag in my book).

As a more value-sensitive investor, I think lululemon looks like a stock for a different breed of investor. If you love to try to get in early on the next big thing, perhaps you should keep looking. For me, though, I'll take a pass. Both Nike and Ralph Lauren look like the kind of companies in which I prefer to invest: strong, stable, growing, and fairly priced. Given the aforementioned cash flow issues, I think Under Armour looks like a stock to avoid.

While lululemon athletica's stock looks like a possible stock for your portfolio depending on your investing style, 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 pique 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 Motley Fool CAPS, 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. lululemon athletica and Under Armour are Motley Fool Rule Breakers picks. Nike is a Motley Fool Stock Advisor recommendation. Under Armour is a Motley Fool Hidden Gems selection. The Fool owns shares of lululemon athletica and Under Armour. 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.