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The Weekday Trader section of Barron's magazine on Thursday, February 9, 2012, published an article titled "A Different Kind of Hospital Stock." The main thesis of the article was that Universal Health Services (UHS) distinguishes itself from its much more ordinary hospital operator competitors. In addition to being the only hospital company that pays a dividend, the article points out that Universal gets approximately 2/3 of its profit from its psychiatric facilities and therefore is outgrowing the rest of the industry. Consequently, the article alleges that this company is being unfairly punished along with ordinary hospital stocks.

Growth stocks are defined as companies with high rates of change of earnings growth of 15% to 20% or better. Growth stocks offer the potential for share prices to rise in lockstep with their profit growth in the long run. Therefore, the PEG ratio formula (price equals growth rate) tends to be the most appropriate formula used to value growth stocks. However, due to the exponential nature of compounding large numbers, PEG ratio forecasts are capped at 40%.

Because of the higher valuation typically awarded to fast growth, growth stocks offer the potential for greater capital appreciation. On the other hand, they also offer higher risk. First of all, they tend to command much higher than average PE ratios, and second, achieving very high levels of growth is very difficult to sustain. Consequently, forecasting future earnings growth is more important with high growth stocks than any other class of stock. Also, the average growth stock typically ploughs all of its profits back into the company to fund its future growth, instead of paying dividends.

Universal Health Services : Large-cap Growth at an Attractive Price

Taken Directly from its website:

Universal Health Services, Inc. is one of the nation's largest and most respected healthcare management companies, operating through its subsidiaries acute care hospitals, behavioral health facilities and ambulatory centers nationwide, in Puerto Rico and the U.S. Virgin Islands. UHS was founded in 1978 by Alan B. Miller, chairman and CEO, and today has more than 65,000 employees. UHS maintains one of the strongest balance sheets and is rated amongst the highest in the hospital services industry by Moody's and Standard & Poor's. This strong capital position has enabled the company to develop and acquire many new facilities over the past few years.

Earnings Determine Market Price: The following earnings and price correlated F.A.S.T. Graphs™ clearly illustrates the importance of earnings. The Earnings Growth Rate Line or True Worth™ Line (orange line with white triangles) is correlated with the historical stock price line. On graph after graph the lines will move in tandem. If the stock price strays away from the earnings line (over or under), inevitably it will come back to earnings.

Universal Health Services : Historical Earnings, Price, Dividends and Normal PE Since 1993.

(Click charts to expand)

Performance Table Universal Health Services

The Two Keys to Long-Term Performance

Years of research and experience have taught us that there are two critically important keys to achieving above-average, long-term shareholder returns at reasonably controlled levels of risk. The first key is earnings growth, or what we like to call the rate of change of earnings growth. The faster a company can grow its business (i.e. earnings), the larger the income stream it can produce with which to reward shareholders. This is because of the power of compounding, which Albert Einstein was alleged to have called "the most powerful force on earth." Ultimately, both capital appreciation and dividend income will be a function of a company's ability to grow its profits.

The second key is valuation. When a company can be purchased at its intrinsic value based on earnings and cash-flow generation, the shareholders' rate of return or long-term capital appreciation will inevitably correlate to and/or equal its earnings growth rate. Overvaluation will lower that rate of return and conversely, undervaluation will increase it. Consequently, paying strict attention to the valuation you pay to buy a stock is a critical component of both greater return and taking lower risk to achieve it. Because, ironically, when you overpay for even the best business, you simultaneously lower your return potential while increasing your risk of achieving the lower return.

The associated performance results with the earnings and price correlated graph, validates the above discussion regarding the two keys to long-term performance. Notice the impact that valuation (black line above or below orange earnings justified valuation line) had on the following performance results.

The following graph plots the historically normal PE ratio (the dark blue line) correlated with 10-year Treasury note interest. Notice that the current price earnings ratio on this quality company is as low as it has been since 1993.

A further indication of valuation can be seen by examining a company's current price to sales ratio relative to its historical price to sales ratio. The current price to sales ratio for Universal Health Services is .55.

Looking to the Future

Extensive research has provided a preponderance of conclusive evidence that future long-term returns are a function of two critical determinants:

  1. The rate of change (growth rate) of the company's earnings
  2. The price or valuation you pay to buy those earnings

Forecasting future earnings growth, bought at sound valuations, is the key to safe, sound, and profitable performance.

Therefore, it logically follows that measuring performance without simultaneously measuring valuation is a job half done. Universal Health Services is clearly an industry leading superior business, which based on the consensus estimates from leading analysts, appears to be capable of growing earnings at an above-average rate for the foreseeable future. At its current price, which is attractively aligned with its True Worth™ valuation, Universal Health Services represents an opportunity for growth at a reasonable price. The important factor is that Universal Health Services, with its strong balance sheet and potential for future earnings growth, has real assets and cash flow underpinning its stock price. This solid economic foundation offers shareholders the potential for both a strong margin of safety and an opportunity for outsized returns.

The Estimated Earnings and Return Calculator Tool is a simple yet powerful resource that empowers the user to calculate and run various investing scenarios that generate precise rate of return potentialities. Thinking the investment through to its logical conclusion is an important component toward making sound and prudent commonsense investing decisions.

The consensus of 19 leading analysts reporting to Capital IQ forecast Universal Health Services' long-term earnings growth at 11.5%. Universal Health Services has long-term debt at 64% of capital. Universal Health Services is currently trading at a P/E of 10.3 which is below the value corridor (defined by the five orange lines) of a maximum P/E of 19.5. If the earnings materialize as forecast, Universal Health Services' True Worth™ valuation would be $114.78 at the end of 2017, which would be a 19.3% annual rate of return from the current price.

Earnings Yield Estimates

Discounted Future Cash Flows: All companies derive their value from the future cash flows (earnings) they are capable of generating for their stakeholders over time. Therefore, because Earnings Determine Market Price in the long run, we expect the future earnings of a company to justify the price we pay.

Since all investments potentially compete with all other investments, it is useful to compare investing in any perspective company to that of a comparable investment in low-risk treasury bonds. Comparing an investment in Universal Health Services with an equal investment in 10-year treasury bonds, illustrates that Universal Health Services' expected earnings would be 8.2 times that of the 10 year T-Bond Interest. (See EYE chart below). This is the essence of the importance of proper valuation as a critical investing component.

Summary & Conclusions

This report presented essential "fundamentals at a glance" illustrating the past and present valuation based on earnings achievements as reported. Future forecasts for earnings growth are based on the consensus of leading analysts. Although, with just a quick glance you can know a lot about the company, it's imperative that the reader conducts their own due diligence in order to validate whether the consensus estimates seem reasonable or not.

Universal Health Services appears to be a very undervalued opportunity to achieve a significantly above average long-term total return. Furthermore, its current uncharacteristically low valuation should mitigate the risk of healthcare overhaul that has driven down most stocks in the hospital industry. As the largest operator psychiatric care facilities in the United States, Universal Health Services appears poised for continued long-term growth. Furthermore, demographics indicate the potential for strong long-term demand.


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Source: Universal Health Services: A Misunderstood Opportunity