Investing in Health Care Stocks

Health care stocks are ownership shares of companies that provide a broad range of medical services, equipment and pharmaceuticals. Health care stocks are different to bio-pharmaceuticals because they include a wider range of companies. The Health care industry is a very large employing millions of people and generating billions of dollars per year in revenue. Investing in health care can be in companies such as hospitals, ambulatory services, hospice care, medical diagnostics and medical treatment including physician services. A few health care companies are illustrated below:

Healthcare companies

Medtronic (MDT): Medtronic is a medical equipment company founded in 1949, with its headquarters in the State of Minnesota. The company distributes its medical devices worldwide. Medical areas in which this equipment is used include heart related disorders, diabetes and spinal applications among others. The company is quite old having been founded in 1949.

Universal Health Services Inc. (UHS): Universal Health Services Inc. is a hospital and acute care facility owner and manager. It's hospitals provide a wide array of health care services throughout much of the Eastern United States in addition to several other states including California, Texas Washington State and Nevada. This company was founded in 1978 and has appreciated in value considerably since then.

Merck (MRK): Merck & Co., Inc. is largely a health care pharmaceuticals company well known for its Viox drug that was recalled in September 2004 due to claims the drug increased the risk of heart attacks. Merck produces many other leading drugs that are used in the health care industry and is a global leader in drug research and manufacturing.

Benefits of healthcare stocks

The health care industry can be considered an inelastic industry. That is to say, due to the high level of specialization and strong demand, changes in prices within this industry are often not met with a decline in demand for medical services. For this reason, the health care industry can be considered to have significant pricing power which is to its advantage.

Another benefit of the owning stocks in the health care industry is the steady demand for health care services. Health care doesn't go out of style and often improvements in the industry spur new demand for specialized technologies domestically and internationally. U.S. Surgeons and various branches of U.S. Health Care are considered some of the best in the World and consequently also draw in revenue from international sources.

Disadvantages of healthcare stocks

There are also potential disadvantages to health care stocks. When health care becomes a political issue and talk of cutting Government support to health care or budgeting health care financing, this can affect the industry in a negative way. Just as government contracts may improve a companies stability, so can removal or redesigning health care financing.

Depending on which branch of health care one is investing in, each has its own particular risks. In the case of ambulatory services, gas prices may reduce profit margins; drug companies may experience bad results in clinical trials leading to a failed research project; hospital may experience heavier than normal emergency related expenses and so forth. When choosing health care stocks it is important to look into these types of details when ascertaining the profitability and performance of the company.

Key metrics

In addition to investigating companies' business operations, they can also be assessed using financial analysis techniques and measurements. A few such measurements that could be of use when determining financial performance of Health care stocks are as follows.

• Price/Sales Ratio: This ratio illustrates how many multiples a company's capital is in relation to its sales. For example, if Company Rx, a large health care services provider, has average capital investments of $64 billion and its annual sales are $12 billion 300 thousand. Its price/sales ratio would be $64billion/12.3 billion=5.2. This means the company's investment financing is over 5 times that of its annual sales. The closer to one this value is the better return a company is making on its invested capital.

• Basis Earning Power (BEP): Basic earning power is a percentage measure of profitability. The percent result is determined by dividing the value of a companies total assets by the value of the company's earnings before interest and tax. In the example of company Rx, their total assets are worth $19.512 billion and their earnings before interest in tax were $3.743 Billion. The resulting BEP outcome is $19.512/$3.743=5.21%. That is to say, the earnings before interest and tax are 5.21% of the total value of assets. Naturally, the higher BEP percentages are more advantageous for a company and its shareholders.

What is the beta coefficient of a stock?

The beta coefficient, also represented by the Greek letter Beta, or the English letter B, is a measure of risk most notably in regard to an equities traded in markets such as stocks. The beta determines price movement relationships alongside broader market indicators such as an index or group of stocks.

The closer the beta value is to the integer 1, the more probable that stock is to move in tandem with broader market movements such as the index. It is important to note, the beta coefficient is calculated using historical prices and should not be interpreted to indicate an exact measurement of future price movements.

Key attributes of the beta coefficient

The beta coefficient has several functions and attributes that make it a unique and important financial equation. The beta is considered a standard statistic in financial analysis and is used in a number of other more complex formulas. A few of the specific features of the beta are listed below:

• Establishes numerical relationships between stock prices and markets over time
• Is an accurate measure of historical price volatility
• Beta is also used in the Capital asset pricing model (CAPM)
• Can be calculated quickly and easily in a number of ways
• Assists in determining price risk
• Calculated using percentage rates of return for 2 or more points in time.

How to calculate the beta coefficient

There are several ways to obtain a beta value including the Microsoft excel statistical tool, a financial calculator, an online financial analysis website or manually using a formula. It can be helpful to understand the math behind a beta in understanding what the beta is. One simple method to calculate the beta is the rise over run method (Brigham and Houston p.277) This method simply takes two historical percentage price points and subtracts them and then divides the difference between corresponding percentage price points in the index.

Beta=Rise over Run=Change in Y (Stock price)/Change in X (Index value)

For example, when company Y had a rate of return of 7% dollars, the index had a return of 5%, and when the index had a return of 2% , company Y had a return of 4%. Using the rise over run equation, the change in company Y (also plotted on the Y axis of a graph) is 3% and the change in the rate of return of the index is 2%.

The change in Y divided by the change in X is equal to 1.5 which is the beta. Since a beta of 1 represents an exact historical price correlation, values higher than 1 are less correlated i.e. numerically related than betas of 1. The further a beta gets from the value 1, the less likely the stock being measured will move with the index if the historical relationship remains constant.

Advantages and disadvantages of the beta coefficient

The beta value is a useful tool to measure price relationships under various market conditions. For example, if there is a recession, a stock with a historical beta of 1 is statistically more probable to also decline in price than a stock with a beta of 2. This is because the stock with a beta of 2 does not necessarily follow market trends. There are several advantages to using beta, most importantly its ability to determine price stability over time. It can also be calculated using many points in time thereby augmenting its statistical validity.

On the other hand, the beta coefficient does have a few disadvantages. Since the calculation is limited i.e. only uses two variables as changed over time, it does not take into account other variables such as inflationary pressures, capital liquidity, financial ratios etc. Such being the case, the beta is restricted to being a potential indicator of price movement in relation to a broader index. Additionally, since market and company conditions can change over time, the beta will not take into account these future changes.

Summary

The beta coefficient is a mathematical value that represents risk of a financial instrument over time in relation to a market. The beta can be easily calculated or obtained and is a standard financial value used in financial analysis. The beta coefficient is a statistical tool based on historical trends and price movements and is therefore not an exact indicator of future price relationships. Rather, the beta coefficient is a useful estimator for determining future price relationships and risk of a particular company or stock.

The beta can be determined under various market conditions to enhance risk and return predictions for a particular asset and/or equity product and can also be calculated using an adjustable range of percentage returns over time. Since the beta value is limited by its variables, it is narrow in its predictive ability. However, the beta coefficient is also an important variable in other financial equations such as the capital asset pricing model (CAPM) and in regression analysis.

Sources:

1. Calculating Beta using excel: http://faculty.babson.edu/academic/Beta/CalculateBeta.htm
2. Eugene F. Brigham, and Joel F. Houston. Fundamentals of Financial Management 9th Ed. South-Western, 1999.p277-281.
3. Howard Bryan Bonham CPA, The complete Investment and Finance Dictionary. Avon Media Corporation, 2001.p.62
4. Zvi Bodei, Alex Kane and Alan J.Marcus. 'Investments' Mcraw-Hill Irwin. New York, 2002. P. 265-271