Everyone would love to find the perfect stock. But will you ever really find a stock that gives you everythingyou could possibly want? One thing's for sure: If you don't look, you'll never find truly great investments. So let's first take a look at what you'd want to see from a perfect stock, and then decide if Eli Lilly(NYSE: LLY) fits the bill.
The quest for perfection
When you're looking for great stocks, you have to do your due diligence. It's not enough to rely on a single measure, because a stock that looks great based on one factor may turn out to be horrible in other ways. The best stocks, however, excel in many different areas, which all come together to make up a very attractive picture.
Some of the most basic yet important things to look for in a stock are:
- Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
- Margins. Higher sales don't mean anything if a company can't turn them into profits. Strong margins ensure a company is able to turn revenue into profit.
- Balance sheet. Debt-laden companies have banks and bondholders competing with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
- Money-making opportunities. Companies need to be able to turn their resources into profitable business opportunities. Return on equity helps measure how well a company is finding those opportunities.
- Valuation. You can't afford to pay too much for even the best companies. Earnings multiples are simple, but using normalized figures gives you a sense of how valuation fits into a longer-term context.
- Dividends. Investors are demanding tangible proof of profits, and there's nothing more tangible than getting a check every three months. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.
With those factors in mind, let's take a closer look at Lilly.
What We Want to See
Pass or Fail?
|Growth||5-Year Annual Revenue Growth > 15%||9.6%||fail|
| ||1-Year Revenue Growth > 12%||8.1%||fail|
|Margins||Gross Margin > 35%||80%||pass|
| ||Net Margin > 15%||21.1%||pass|
|Balance Sheet||Debt to Equity < 50%||57.5%||fail|
| ||Current Ratio > 1.3||2.33||pass|
|Opportunities||Return on Equity > 15%||43.2%||pass|
|Valuation||Normalized P/E < 20||9.19||pass|
|Dividends||Current Yield > 2%||5.8%||pass|
| ||5-Year Dividend Growth > 10%||5.6%||fail|
| || || || |
| ||Total Score|| ||6 out of 10|
Source: Capital IQ, a division of Standard and Poor's. Total score = number of passes.
Lilly clocks in with a score of 6, which is a good showing. Unfortunately, many of Lilly's biggest challenges lie directly ahead.
Lilly has been putting up strong numbers for a while now. In its most recent quarter, the company trounced analysts' expectations on earnings, thanks largely to major cost-cutting initiatives that have helped make the most of fairly stagnant revenue. Yet when you compare Lilly to its large pharma peers, Merck (NYSE: MRK), Pfizer (NYSE: PFE), and Abbott Labs(NYSE: ABT), Lilly has by far the cheapest valuation and also beats the others in dividend yield by between 1 and 2 percentage points.
More than even other companies, though, the problem for Lilly is in its drug pipeline. Approval of its diabetes drug Bydureon, on which it partners with Amylin Pharmaceuticals(Nasdaq: AMLN) and Alkermes (Nasdaq: ALKS), was unexpectedly delayed for as much as 18 months. Other promising drugs in its pipeline have failed to pan out this year. And with many of its mainstay moneymakers coming off patent protection in the next few years, Lilly is particularly vulnerable.
That isn't to say that Lilly is dead in the water. Many drug companies are turning to acquisitions to try to goose pipeline growth, and Lilly has more than sufficient financial resources to court prospective buyout candidates. But until its uncertainty resolves itself one way or the other, Lilly will fall short of perfection.
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.
© 2010 UCLICK L.L.C.