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This Ratio Explains Why I’d Buy AstraZeneca plc Today

AstraZeneca (LSE: AZN) (NYSE: AZN.US) has been much abused for its failure to invest in new products during the reign of ex-CEO David Brennan, and is undoubtedly suffering the consequences now, with both sales and earnings expected to fall for the next couple of years.

However, I reckon that investors might be overlooking one key factor, which suggests that AstraZeneca is already outrageously cheap compared to GlaxoSmithKline — and that now could be a cracking time to buy into Astra.

An important ratio

The faithful price-to-earnings ratio is a great tool for comparing the price of two similar companies, but sometimes it doesn’t tell the whole story. One problem in particular is with debt — the P/E ratio only looks at market capitalisation, and does not reflect a company’s debt levels.

For this reason, anyone considering buying a company usually shuns the P/E ratio and instead calculates the enterprise value to EBITDA ratio. Enterprise value is the true cost of a company — the sum of its market capitalisation and net debt — while EBITDA is earnings before interest, tax, depreciation and amortisation, which provides a measure of a firm’s raw profits.

By now you’ve probably guessed what’s coming — on an EV/EBITDA basis, AstraZeneca is exactly half the price of GlaxoSmithKline.

Why is AstraZeneca so cheap?

AstraZeneca currently boasts a modest EV/EBITDA ratio of 5.6, while Glaxo trades on a heady EV/EBITDA of 11.2.

Some of this pricing discrepancy can be accounted for by the fact that, unlike Astra, Glaxo has largely recovered from the patent cliff. But there must be another explanation, as well.

I think that the real reason for this massive difference in valuation is debt. Borrowing costs for big companies are low at the moment, and markets seem to be ignoring the risk that borrowing might become more expensive in the future, or that profits might fall, making it harder for companies to service their debts and pay dividends.

Glaxo has net debt of £15.7bn, giving it net gearing of 245%. AstraZeneca, in contrast, had net cash until the end of 2011, and currently has net gearing of just 5.6%.

This difference isn’t reflected in the valuations of the two companies, but I think it will be eventually, making AstraZeneca a very affordable and safe buy today, despite its short-term earnings weakness.

This top expert rates AstraZeneca

High-yielding pharma giants AstraZeneca and GlaxoSmithKline are two of the eight largest holdings of top UK fund manager Neil Woodford.

Neil Woodford's stock picks have an impressive record -- if you'd invested £10,000 into Mr Woodford's High Income fund in 1988, it would have been worth £193,000 at the end of 2012 -- a 1,830% increase!

If you'd like access to an exclusive Fool report about all eight of Neil Woodford's largest holdings, then I recommend you click here to download this free report, while it's still available.

> Roland owns shares in GlaxoSmithKline but does not own shares in AstraZeneca. The Motley Fool has recommended GlaxoSmithKline.