Financial Ratio Analysis and Investment Thesis for CVS

As an investor, discuss which company you would choose to invest in and provide a rationale for your decision. Support your conclusions, why or why not?

I would choose to invest in CVS. First, the company is trading a lower multiple to earnings than Walgreen which indicates that the investor is obtaining more value per dollar of earnings relative to Walgreens. This is particularly attractive in a low interest rate environment in which many stocks trade at a historically high P/E multiple. This many also cause some concern for me as even during a bull market, both CVS and Walgreens are trading a relatively low multiples. This could potentially indicate problems with the overall operations for both businesses as the market is may be capitalizing lower future earners for both businesses. CVS has a lower dividend payout ratio relative to Walgreens. This indicates more security for investors as to the ability to pay future dividend. Likewise, the company is able to retain a greater portion of earnings within the business to better position its balance sheet in the form of cash, or to reinvest back into the business. Walgreens however, paid out nearly 3 times its earning in the form of dividends which is unsustainable. It appears the at Walgreens suffered adverse business operations during COVID-19 and thus was reluctant to reduce its dividend as investor could potentially see the decline as a lack of confidence for the future. As such, the company has maintained the dividend, in hopes of a business recovery into the future. This appears somewhat risky from an investor perspective as the future is uncertain. If an unforeseen event occurs in the market, Walgreens will undoubtedly need to reduce its dividend. CVS does have a higher debt to equity ratio relative to Walgreens, but this can be reduced by the larger retained earnings in the business if warranted. A higher debt level can potentially be justified as the company may be taking advantage of historically low interest rates as well. If the company can earn returns higher than the rate at which it issues debt, then the results should be accretive to owners of the business.

After concluding your research about each company and reviewing their annual report, discuss what non-financial criteria you would consider when choosing between these two investment options? Support your conclusions, why or why not?

The first non-financial criteria I would consider is management candor. Stocks are an ownership claim to the business and therefore shareholders are essentially partners in the business. The CEO is the head of this partnership and should be able to have honest discussions with the shareholders through his annual report. As a result, I would want to look at how honest the management is being with investors as it relates to problems, solutions, and any other data shareholders would need to evaluate the business. This is critical as the CEO is a steward of capital (Boudreaux, 1977).

The next non-financial metric I would look at is the overall economic moat of the franchise. Has the franchise moat expanded or declined over the period? Have competitors made inroads within the competitive landscape and if so, what are the companies combating it. This is critical as it is the nature of capitalism and “creative destruction” to reduce the overall returns to shareholders to an average level. This competition ultimately provides consumers with better products and lower prices. Business with sustainable competition advantages (Apple, Costco, Nike, UPS, etc.) can earn high returns as it is very difficult to compete. In the case of Walgreens and CVS, is very difficult, but not impossible to replicate their distribution networks. As a result, both companies can operate at scale with relative low costs. However, they are not a low-cost producer. During COVID-19 we saw consumers shift to Wal-Mart, Costco, and online fulfilment to mitigate the impacts of job loss. As a result, business operations for both Walgreen and CVS suffered. In this instance, I would want to see I the competitive positions of both franchises changed in a material way that would ultimately impact returns and earnings on the business (Bennett, 2006).