Warren Buffett (Trades, Portfolio) once said, “Price is what you pay, value is what you get.” This statement is especially true in regard to Intuitive Surgical Inc. (ISRG, Financial).
The medical devices manufacturer is a classic example of why valuation is a key factor that should never be neglected in stock picking. I argue that this health care stock could have been a top choice for long-term investing, but it is not. While it has strong fundamentals and a solid balance sheet, the valuation is not in sync with the share price currently.
Intuitive Surgical has a strong balance sheet in an era of rising interest rates
Shares of Intuitive Surgical are down nearly 1.5% so far in 2023.
With a beta of 1.49, theory suggests that with a 10% decline of the broader market, the stock will drop around 14.90%. Are we in a bear market yet? This will be determined by the way the stock market reacts to the company's earnings results as well as higher interest rates.
As such, it is very nice to find companies like Intuitive Surgical that have little to no debt in an environment where capital gets more expensive as interest rates rise. The company has zero long-term debt; not just for fiscal year 2022, but also for the whole period of 2019 through 2022. This is indeed remarkable because when capital was cheap before the U.S. Federal Reserve started to tighten its monetary policy, Intuitive Surgical did not fund its growth via debt.
The fundamentals are very strong, but there is a setback to consider
Not only does Intuitive Surgical have a very solid balance sheet, but it is also financially strong, which is good news. By analyzing the fundamentals, investors can see why I think the company has potential. It has to do with the trend in key metrics such as revenue, earnings per share and book value, which have respective three-year average growth rates of 11.20%, -1.80% and 9.90%.
Further, according to MSN, the health care company has a three-year average growth rate of 67.47% for its gross margin, 27.11% for its operating margin and 25.15% for its net margin.
In addition to this very encouraging profitability, the company generates a lot of positive free cash flow. Intuitive recorded $958.40 million in free cash flow for 2022, which was down from $1.74 billion in 2021.
The slowdown in free cash flow growth also affected the growth of the company's revenue and earnings per share for the year. Intuitive Surgical reported revenue growth of 8.97%, less than the three-year average rate of 12.43%, and earnings growth of -21.61%, which was less than the three-year growth rate of 4.45%.
The free cash flow in 2022 declined 44.21%, which compared to a three-year average growth rate of 0.81%. Since free cash flow is a top factor for valuation purposes, a slowdown is not an optimistic sign for the value of any company.
The valuation is too rich
The shares of Intuitive Surgical have a trailing 12-month price-earnings ratio of 71.13. This seems very high, but, as always, it is important to consider the average ratio of the sector in which it operates. The relative valuation of Intuitive Surgical's stock shows that it is now trading at a very high premium compared to the industry median of 26.94. A premium that is too high could soon lead to a convergence of the stock price with its intrinsic value. In other words, the stock could move lower.
Further, there is not a single valuation metric that makes shares of Intuitive Surgical look cheap.
For instance, the forward price-earnings ratio of 49.14 compares to the health care sector's median ratio of 25.07. Other forward financial ratios, such as enterprise value/sales and enterprise value/Ebitda, show a huge premium that makes it hard to consider Intuitive Surgical as a value stock. Additionally, the forward price-sales ratio of 13.30 is well above the sector median of 4.14. If the price-to-free cash flow ratio was at least attractive, would that change the perspective and make Intuitive Surgican a potentially attractive option?
I argue that investors should consider potential investments based on a plethora of financial metrics, not just one. Is it a surprise, then, that even the forward price-to-free cash flow ratio is higher than the sector median? What are we missing, and what makes the stock have a very large premium based on not just one but a number of financial metrics? In a word, exuberance.
I find shares of Intuitive Surgical to not be attractive at current prices for all of these reasons. There is no bargain to discover here.
