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 and
  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 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 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 Dr. Pepper Snapple (NYSE: DPS) 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

Dr. Pepper Snapple

11.9%

18.7%

3.3%

106.4%

Coca-Cola (NYSE: KO)

32.2%

26.6%

8.3%

80.4%

PepsiCo (NYSE: PEP)

36.0%

17.9%

9.5%

114.9%

Starbucks (Nasdaq: SBUX)

22.3%

9.4%

18.1%

12.7%

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

Dr. Pepper Snapple looks like an average business, generating pretty meager returns on equity and growth.  However, it does have a somewhat impressive EBIT margin. Its financing seems reasonable but not entirely riskless.

Coke, on the other hand, shows what many market observers (including The Oracle of Omaha himself) regard as one of the better business on the planet. Coke generates mouth-watering returns on equity and margins. Although lacking the double-digit growth you see in many areas such as tech, its growth rate seems solid nonetheless.

Similar to Coke, PepsiCo demonstrates very impressive ROE and margins. It has a growth component but won't overwhelm investors looking for growth. It has the most aggressive capital structure among the four, something for investors to watch closely.

Starbucks generates an above average ROE and has the best growth out of the four firms shown here (by a wide margin). It also has the lowest margin out of the pack. However, the company should lack any real financial risk with its extremely conservative capital structure.

How cheap does Dr. Pepper Snapple 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

Dr. Pepper Snapple

8.3

18.0

Coca-Cola

27.3

13.2

PepsiCo

26.6

19.1

Starbucks

28.3

25.6

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

Dr. Pepper Snapple looks extremely cheap on a cash flow basis. On the other hand, it looks more expensive than I'll typically pay for a firm on an earnings basis. The other three companies all look either fairly priced or more expensive than desired. All in all, I don't see a lot of opportunity here.

This industry plays host to some outstanding businesses. However, I don't see a really high conviction risk-reward scenario present here. Smart investors prefer to wait patiently for real bargains rather than forcing the issue to buy fairly valued stocks.

All-in-all, Dr. Pepper Snapple doesn't look like a stock for your portfolio right now. However, 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. The Motley Fool owns shares of PepsiCo, Starbucks, and Coca-Cola. Motley Fool newsletter services have recommended buying shares of PepsiCo, Coca-Cola, and Starbucks. Motley Fool newsletter services have recommended creating a diagonal call position in PepsiCo. 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.