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 Zimmer Holdings (NYSE: ZMH) 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

Zimmer Holdings

14.15%

30.18%

1.12%

19.47%

Stryker (NYSE: SYK)

19.89%

23.27%

14.78%

13.75%

Integra LifeSciences (Nasdaq: IART)

10.88%

15.65%

12.40%

69.21%

Medtronic (NYSE: MDT)

21.16%

30.85%

6.46%

61.59%

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

Zimmer Holdings looks decent on paper.  It generates a slightly below average return on equity and its operating margin looks healthy.  The real issue appears on the growth frontier.  Averaging less than 2% growth annually over the last half-decade seems like a real issue.  That being said, I do like its conservative financing.

Stryker looks quite similar to Zimmer only with better past growth.  It has a better ROE and a weaker operating margin, although neither looks unduly weak in its own right.  It has the most conservative capital structure out of the companies listed here.

Integra LifeSciences has the weakest return on its equity base and smallest EBIT margin. It does have decent growth, but its capital structure is the most aggressive of this foursome.

Medtronic produces the highest average returns for its equity and operating margins despite some weak past growth.  Its capital structure, while in the higher range of the companies seen here, looks stable.

How cheap does Zimmer Holdings 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

Zimmer Holdings

16.03

22.49

Stryker

17.52

19.62

Integra LifeSciences

28.09

25.09

Medtronic

15.63

14.13

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

From a pricing standpoint, many of these firms look either fairly priced or too expensive to make a sound buy.  Only Medtronic looks reasonable cheap (less than 16 times) on both multiples.  These higher-than-desired multiples give me some trepidation about these stocks.

Investors always need to require they receive adequate compensation for the risks of owning stocks.  In the end, only Medtronic looks like it has a possibly favorable risk-reward proposition.

While Zimmer Holdings 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. The Motley Fool owns shares of Zimmer Holdings and Medtronic. Motley Fool newsletter services have recommended buying shares of Stryker. 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.