The healthcare sector has been one of the best-performing sectors over the last decade on the ASX and with names like ResMed Inc. (CHESS) (ASX: RMD), CSL Limited (ASX: CSL) and Ramsay Health Care Limited (ASX: RHC) it's not hard to see why.
These shares always seem to appear expensive when compared to the broader market but it would be wise to remember one of Warren Buffett's most famous quotes when thinking about these companies – "Price is what you pay. Value is what you get."
Too often investors focus on price and forget about value. Just because a particular share looks cheap, is offering a massive dividend yield or has dropped by 50% doesn't necessarily mean the stock is good value for the long term investor.
Don't get me wrong – the price you pay for an investment will ultimately determine your final return but it's important to remember a company's share price in the long run will be determined by its financial performance and this should always be the initial focus for every long term investor. As a result, I think investors first need to consider the fundamentals of a business and then decide if the shares are trading at a price which offers a large enough degree of safety if something goes wrong.
Although it is difficult to forecast what the financial performance of any company will likely be in 10 years time, investors can still get a good idea of where the company is heading by looking at its historical performance.
Let's take ResMed as an example.
ResMed is a leading global developer and manufacturer of medical devices for sleep apnoea and other respiratory related disorders. It already sells its products in around 100 countries but there still remains a huge untapped market for its products especially as many of its potential customers are yet to be diagnosed.
The success of ResMed so far and the great returns it has delivered to shareholders can be explained by looking at its historical financial performance since 2008.
One of the most important indicators of its success has been the ability to increase its incremental return on equity (ROE) for shareholders. Since 2008, ResMed's ROE has steadily increased from 10.5% to the current figure of 22%. This means that for every $1 of shareholder capital invested, ResMed now generates around 22 cents worth of profit each year compared to just 10 cents in 2008. Importantly, this has been achieved with the minimal use of debt which can often inflate the return of equity figure when company's decide to borrow funds to grow, instead of using retained earnings.
As mentioned above, ResMed's debt levels are conservative, with a gross debt-to-equity ratio of around 25%. In addition to this, the company has a cash balance in excess of A$940 million and this leaves the balance sheet in an extremely strong position to pay out dividends to shareholders whilst providing flexibility for further research and development.
Another measure of ResMed's excellent financial performance has been its ability to consistently increase its cash flow per share. In 2008, ResMed was generating cash flow of 9.1 cents per share compared to 34.9 cents per share in 2015. That's an increase of more than 280% in the space of eight years!
Finally, ResMed's earnings per share (EPS) have also significantly increased since 2008. In 2015, the company generated 32.3 cents of profits for every share compared to just 7.5 cents in 2008.
One point investors should note, however, is that the sleep apnoea and respiratory disorders market is becoming more competitive with a number of other companies aggressively expanding into the sector. This could place pressure on ResMed's margins in the future and is a factor investors will need to watch closely moving forward.
Foolish takeaway
The future financial performance of a company can never be entirely certain, but looking at a company's historical performance can give investors an idea of how the company is operated and whether or not management is working for the interests of shareholders.
In the case of ResMed, it is in a very healthy financial position with a strong growth outlook. What price you should be willing to pay for this performance and growth is a matter of opinion but I believe investors who purchase a piece of the business today will enjoy excellent returns over the next decade or so.
