Does This Metric Tell Investors All They Need to Know About Gilead Sciences?

In his book The Outsiders, author Will Thorndike highlights eight skilled capital allocators who succeeded by being unconventional in how they spent money. The decision to launch only projects that will have a favorable return, Thorndike explains, may seem like common sense, but it's not the approach CEOs typically take, or the one Wall Street expects.

This is largely explained by the owner-versus-manager mindset. Owners are driven by accountability -- and a desire to spend the company's money as if it were their own. After all, when you own a business, expenses and investments are essentially coming out of your pocket.

Conversely, the manager mindset is one of hierarchy and bureaucracy, where building larger teams -- and, by extension, a larger organization -- is the goal. Managers won't hesitate to acquire a business that doubles the size of the company, because it means they'll be managing twice the enterprise. Many executives (most, even) are actually incentivized to make these deals; managing a larger company means getting paid more money. But an owner balks at such deals and asks, "Where will the money generate the greatest return?"

It can be difficult to distinguish between owners and managers when considering the leadership teams of the companies you invest in, but one metric helps to identify those who will treat your money as if it were their own. Potential Gilead Sciences (NASDAQ: GILD) shareholders would be wise to pay attention to this metric, and how it trends, when weighing an investment in the drugmaker.

several different colored pills, a syringe, and the letters HCV on paper

Image source: Getty Images

Investors' typical focus

For many investors, nothing is as exciting as revenue growth. Companies that rapidly grow sales can usually spend money at will without losing shareholder support. In many industries, getting big quickly allows a company to crush competition and establish itself as the de facto choice. Also, high revenue growth can cure a lot of poor expense management -- when a company keeps growing sales at 30% or even 40% per year, it becomes hard not to make a profit, because spending naturally doesn't keep up the same pace.

More traditional investors, meanwhile, will focus on earnings per share. Typically, the first metric investors learn is the P/E ratio. Derived from two very straightforward, accessible numbers -- share price divided by earnings per share, or EPS -- this ratio becomes the shortcut for investors trying to find a bargain.

Finally, conservative investors and those seeking income, like retirees, will focus on a company's dividend. Dividends aren't guaranteed; they're a return of capital to shareholders, rather than a reinvestment into the business. While many investors use this metric to choose a stock to invest in, focusing solely on dividend yield can prove unwise if the dividend gets cut and/or the share price underperforms the overall market.

What investors should focus on

There is one metric that does provide insight into how effectively management is allocating capital to projects that pay off. Although the daily rise and fall of stocks can be random, long term gains are driven by how well management invests in opportunities that generate a return. Return on invested capital (ROIC) measures the return management is getting on the money it spends. It is essentially after-tax profit divided by the amount of money it takes to run the business (debt plus equity). This is a useful way to evaluate a business whether it builds software, sells candy bars, or operates a car wash.

How Gilead stacks up on the typical metrics

Gilead's revenue has remained largely the same for three years. Despite an $11.9 billion pivot to cancer therapies with the acquisition of Kite Pharma in 2017, revenue has declined. The recently announced $21 billion acquisition of Immunomedics (NASDAQ: IMMU) puts breast cancer treatments under the company's umbrella in another attempt to jump-start sales.

Meanwhile, ROIC has declined from more than 50% to the modest single digits. This is trending toward the bottom of the list for large pharmaceutical companies. Novo Nordisk (NYSE: NVO) leads the pack with nearly 70%, but even a diversified blue-chip company like Johnson & Johnson (NYSE: JNJ) has ROIC above 17%.

GILD Return on Invested Capital (3y Median) Chart

GILD return on invested capital (3-year median) data by YCharts.

Where Gilead fails -- and why it's important

This trend of declining returns may come as no surprise to investors who have seen their Gilead shares plunge nearly 50% from previous highs and stay there. The precipitous drop was partly because the company's revolutionary hepatitis C drugs cured most patients (preventing repeat sales), and partly because competition forced lower prices.

GILD Chart

GILD data by YCharts.

Amazon founder Jeff Bezos is a fan of ROIC, calling it out specifically in his first shareholder letter in 1997. His company prioritizes precious few outcome metrics, choosing to focus on controllable inputs instead, so it is telling that ROIC makes the list.

Gilead has seen its revenue and EPS stagnate, and has enticed investors with a juicy dividend yield. Ultimately, the company has spent cash, added debt, and increased equity to make large acquisitions in an attempt to restart the growth engine. This has driven ROIC lower than most of its peers. With the Kite acquisition yet to yield significant growth, investors either believe the Immunomedics purchase will change the trajectory of the business or need to find a new place for their money.

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Jason Hawthorne has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Gilead Sciences. The Motley Fool recommends Immunomedics, Johnson & Johnson, and Novo Nordisk. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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