Does Green Mountain Coffee Roasters Deserve a Spot in Your Portfolio?

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 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 5-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 Green Mountain Coffee Roasters (Nasdaq: GMCR) and some of its closest peers.

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

Starbucks looks like the clear leader in terms of the returns it generated over the last five years. These companies all have healthy operating margins that lie within a pretty close band of each other. While Peet's and Starbucks have grown their operating earnings substantially over the last half-decade, Green Mountain takes the cake for its past growth. Sara Lee's growth looks pretty anemic. Another negative, Sara Lee looks like the only company with a risky debt burden. However, this makes up only part of the price/value equation.

How cheap does Green Mountain Coffee Roasters 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.

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

Many of Green Mountain's critics' negative comments are laid bare in this chart. The company generates negative cash flow and looks extremely expensive relative to its earnings. Although a growth story, its lack of current cash flow certainly worries me. More generally speaking, these companies all look expensive on both a cash and earnings basis.

Overall, this set of companies, although producing some respectable performances, look too pricey for my taste. Especially with lingering concerns over the health of the global economy mounting, I might think twice about buying at present.

While Green Mountain Coffee Roasters' 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, 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.