Quest Diagnostics (DGX) provides diagnostic testing and interpretive consultation. DGX announced its third quarter earnings on October 25. It reported that “adjusted income from continuing operations was $189 million, or $1.18 per diluted share.” In comparison, for the third quarter 2010, DGX “reported income from continuing operations was $198 million, or $1.13 per diluted share.” DGX also reported, “Revenues increased 2.2% to $1.9 billion for the third quarter.” The share price for DGX increased on the news, going from $50.98 at close on October 24, to close at $56.50 on October 25.
Of course, strong earnings do not always mean a good buy. There are other factors to consider, like its cash conversion cycle. Otherwise, all you are looking at is a snapshot of the company, not a broader view of its potential to earn profits for investors – you aren’t getting a good view of the company’s worth or the stock’s actual value.
While not everyone is a pro when it comes to company valuation, there are a few metrics anyone can use to get an approximation of a stock’s real value: the current price multiples, the consistency of past earnings and cash flow, the amount of growth expected. Let’s see what these numbers can tell us about DGX.
CURRENT PRICE MULTIPLES
First, we will look at the P/E ratio. This metric divides a company’s share price by its earnings per share – the lower the number, the better. P/E ratio indicates how many times its earnings a company is trading at. If the P/E ratio is high, the stock could be overpriced.
Next, we will take a look at the company’s enterprise value to unlevered free cash flow. To get this metric, we will divide the company’s enterprise value (market cap plus debt minus cash) by its unlevered free cash flow (just free cash flow with interest payments added back in). The lower this number, the better. Like with the P/E ratio, if this number is too high it means the stock is likely overpriced.
There are two different camps of thought on this subject, each thinks the other multiple is more important, but they agree on one common aspect. The lower these multiples are the better. DGX has a P/E ratio of 20.71 and an EV/FCF of 18.60.
To get some perspective on DGX’s numbers, let’s look at its closest competitors – Laboratory Corporation of America (LH), Psychemedics Corporation (PMD) and CardioNet (BEAT). LH has a lower P/E ratio than DGX, reporting 17.01 compared to DGX’s 20.71. PMD has an even lower P/E ratio, coming in at 14.67 while BEAT has the lowest P/E ratio, at 10.84. BEAT also has the lowest EV/FCF, coming in at 11.80 compared to DGX’s 18.60. PMD, which had the second lowest P/E ratio of the companies we looked at, had a slightly higher EV/FCF comparatively, coming in at 16.68. LH was a little lower. Its EV/FCF was 14.81.
An ideal investment has strong consistency in its earnings. It would have a small range for its free cash flow yield. DGX’s cash flow yield over the last five years ranges from 6.05% to 11.19%, for an average of 8.24%. LH has an equally broad range, going from 5.27% to 10.48% over the last five years, averaging just a little under DGX at 8.12%. PMD had a broader range (3.82% to 9.99%) and a lower average at 5.72%. BEAT had the broadest range and was the only stock we looked that averaged a loss over the last five years. BEAT ranged from -10.80% to 6.71%, for an average of -0.84%. Now that we know where these stocks have been, let’s take a look at their expected growth.
Expected growth estimates can be wrong. In fact, they are frequently overstated, but they can be useful when comparing companies or comparing a company’s performance relative to its industry. In the case of DGX, it reported 8.1% growth over the last five years, which sounds great until you look at the industry, which returned 13.4% in the same period. For the next five years, DGX is expected to grow 11.4%, an improvement over the last five years but still less than the industry forecast of 15.2%. In comparison, LH did better, growing 15.5% over the last five years, but it is expected to grow by just 12.3% over the next five years. In contrast, BEAT is expected to swell 25% over the next five. PMD lost 7.9% over the last five years. Earnings growth estimates were not available for PMD but its year over year earnings growth estimate for next year is 9.54%.
THE BOTTOM LINE
We’ve looked at DGX’s and its closest competitors’ price multiples, operational performance and growth. Out of all these, we think that DGX and LH are holds. Both stocks are favored in the hedge fund community. John Shapiro’s Chieftain Capital has more than $123 million in LH while Ric Dillon’s Diamond Hill Capital has over $119 million invested in DGX. BEAT, a favorite of Israel Englander’s Millennium Management, will likely outperform but may not be priced to buy right now. The outlook for PMD isn’t great but it seems to be priced low enough for a profit.
In any case, these stocks seem somewhat overpriced compared to consumer favorite stocks like the Coca-Cola Company (KO). KO has a low P/E ratio of 12.56 and is expected to grow by 8% over the next five years. Chevron Corporation (CVX) has a similar profile. It has a P/E ratio of 9.17 and is expected to grow by 7.5% over the next five years.