Previously in this series, we saw that Applied Materials (AMAT) stock is undervalued, as US–China trade tensions made investors cautious and triggered selling activity. With cheaper valuations and strong growth potential, AMAT looks like an attractive buy for long-term investors.
However, growth alone doesn’t reflect the value of a company. Investors also look at the earnings a company delivers against the investments it makes. This comparison shows the ability of a company’s management to generate higher returns from lower investments. The management’s efficiency is measured using efficiency ratios.
Return on investment
ROI (return on investment) measures the income a project or a company earned on a certain level of investment. Long-term investors and companies use ROI to compare investment opportunities and identify those that generate the highest returns from the same investment.
ROI is subject to a company’s capital structure. One cause of LRCX’s lower ROI could be its higher WACC (weighted average cost of capital) of ~10.0%, compared with AMAT’s and KLAC’s WACC metrics of ~8.0% and 7.3%, respectively. It remains to be seen whether AMAT can maintain or increase its ROI in its upcoming April quarter earnings report, which is scheduled for May 17.
Return on equity
A better measure for regular shareholders is a stock’s ROE (return on equity), as it shows the profit a company can generate from shareholder capital. ROE also factors in a company’s capital structure. If a company issues new shares or debentures convertible into shares, the dilutive impact on the stock reduces its ROE.
In the January quarter, AMAT had an ROE of 35.4%. In the March quarter, KLAC and LRCX had ROEs of 56.4% and 27.8%, respectively. There are two ways to increase ROE—reduce the number of outstanding shares through a stock buyback or increase the company’s net income.
KLAC has a higher ROE, as its earnings per share (or EPS) of $2.02 are higher than AMAT’s estimated EPS of $1.14 for the March quarter.
What efficiency and price ratios say about AMAT
Looking at its efficiency and price ratios, AMAT is a cheaper stock compared to KLAC, as investors haven’t priced in the earnings potential of AMAT. KLAC’s higher ROE made investors more optimistic about it than AMAT, although the former’s estimated earnings growth rate is lower than the latter’s growth rate.
AMAT increased its stock buyback authorization by $6.0 billion, doubled its dividend per share, and is working to improve its profits to improve its ROE.
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