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:
- The business's ability to generate profits.
- 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 EBIT margin, or Earnings Before Interest and Taxes, 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. However, generally speaking for this figure, the lower, the better. 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 Cisco Systems
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.
Cisco looks like the clear leader of the group, generating impressive margins and returns while using a conservative capital structure. Its growth over the last half-decade looks a little paltry though. On the other hand, Alcatel-Lucent’s business seems to have hit the skids. Its business produced negative average returns and growth over this period. Couple that with higher-than-desired leverage and a weak margin and it appears to be business to avoid. Riverbed Technology looks like the growth story of the pack. By issuing equity rather than debt to finance itself, the company certainly expanded its business rapidly. However, the business looks only reasonably profitable despite its huge growth. F5 Networks is like the only firm whose performance really competes with Cisco. It generates healthy (but not eye-popping) returns with impressive margins and growth.
How cheap does Cisco 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. NM = not meaningful because of losses.
This really puts the investment merit of these companies into perspective. Given its substantial performance, Cisco looks cheap, despite its lingering growth issues. Because of losses, Alcatel-Lucent doesn’t register figures for either metric. Given its current losses, Alcatel-Lucent seems like a business to totally avoid. With its big growth, Riverbed looks priced to continue to grow. Similarly, F5 looks richly priced, also because of expectations of future growth.
In reviewing these numbers, Cisco’s stock looks extremely appealing. Punished for lacking growth, the company looks undeservedly cheap -- especially considering it still has some growth. In the rest of the pack, F5 Networks looks more expensive, but like a viable stock to learn more about. Both Riverbed and Alcatel-Lucent look like stocks to avoid. Alcatel’s business seems on the down and out. Riverbed, although growing, used stocks issuance to drive its growth (hurting current shareholders) -- a red flag from my perspective.
While Cisco Systems stock looks like a great 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 are all 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. Riverbed Technology is a Motley Fool Rule Breakers choice. The Fool has created a bull call spread position on Cisco Systems. Alpha Newsletter Account, LLC owns shares of Cisco Systems. 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.