Red Hat, Inc. (NYSE:RHT) and Nuance Communications, Inc. (NASDAQ:NUAN) are the two most active stocks in the Application Software industry based on today’s trading volumes. Investors are clearly interested in the two names, but is one a better choice than the other? We will compare the two companies across growth, profitability, risk, valuation, and insider trends to answer this question.

**Growth**

The ability to consistently grow earnings at a high compound rate is a defining characteristic of the best companies for long-term investment. Analysts expect RHT to grow earnings at a 16.94% annual rate over the next 5 years. Comparatively, NUAN is expected to grow at a 1.00% annual rate. All else equal, RHT’s higher growth rate would imply a greater potential for capital appreciation.

**Profitability and Returns**

Just, if not more, important than the growth rate is the quality of that growth. Growth can actual be harmful to investors if it comes at the cost of weak profitability and low returns. To adjust for differences in capital structure we’ll use EBITDA margin and Return on Investment (ROI) as measures of profitability and return. Red Hat, Inc. (RHT) has an EBITDA margin of 18.45%, compared to an EBITDA margin of 16.74% for Nuance Communications, Inc. (NUAN). This suggests that RHT underlying business is more profitable. RHT’s ROI is 13.30% while NUAN has a ROI of 2.80%. The interpretation is that RHT’s business generates a higher return on investment than NUAN’s.

**Cash Flow **

Cash is king when it comes to investing. RHT’s free cash flow (“FCF”) per share for the trailing twelve months was +1.28. Comparatively, NUAN’s free cash flow per share was +0.41. On a percent-of-sales basis, RHT’s free cash flow was 9.46% while NUAN converted 6.07% of its revenues into cash flow. This means that, for a given level of sales, RHT is able to generate more free cash flow for investors.

**Liquidity and Financial Risk**

Liquidity and leverage ratios measure a company’s ability to meet short-term obligations and longer-term debts. RHT has a current ratio of 1.30 compared to 1.20 for NUAN. This means that RHT can more easily cover its most immediate liabilities over the next twelve months. RHT’s debt-to-equity ratio is 0.58 versus a D/E of 1.33 for NUAN. NUAN is therefore the more solvent of the two companies, and has lower financial risk.

**Valuation**

RHT trades at a forward P/E of 33.41, a P/B of 14.32, and a P/S of 7.42, compared to a forward P/E of 14.10, a P/B of 2.31, and a P/S of 2.31 for NUAN. RHT is the expensive of the two stocks on an earnings, book value and sales basis. Given that earnings are what matter most to investors, analysts tend to place a greater weight on the P/E.

**Analyst Price Targets and Opinions**

A cheap stock is not necessarily a value stock. Most of the time, a stock is cheap for good reason. A stock only has value if the current price is substantially below the price at which it should trade in the future. RHT is currently priced at a -1.82% to its one-year price target of $107.48. Comparatively, NUAN is -26.71% relative to its price target of $21.38. This suggests that NUAN is the better investment over the next year.

The average investment recommendation on a scale of 1 to 5 (1 being a strong buy, 3 a hold, and 5 a sell) is 2.10 for RHT and 1.90 for NUAN, which implies that analysts are more bullish on the outlook for RHT.

**Risk and Volatility**

No discussion on value is complete without taking into account risk. Analysts use a stock’s beta, which measures the volatility of a stock compared to the overall market, to measure systematic risk. A stock with a beta above 1 is more volatile than the market. Conversely, a beta below 1 implies a below average level of risk. RHT has a beta of 1.22 and NUAN’s beta is 0.68. NUAN’s shares are therefore the less volatile of the two stocks.

**Insider Activity and Investor Sentiment**

The analysis of insider buying and selling trends can be extended to the aggregate level. Short interest, which represents the percentage of a stock’s tradable shares currently being shorted, captures what the market as a whole feels about a stock. RHT has a short ratio of 1.94 compared to a short interest of 2.52 for NUAN. This implies that the market is currently less bearish on the outlook for RHT.

**Summary**

Red Hat, Inc. (NYSE:RHT) beats Nuance Communications, Inc. (NASDAQ:NUAN) on a total of 8 of the 14 factors compared between the two stocks. RHT is growing fastly, is more profitable, generates a higher return on investment, has higher cash flow per share, has a higher cash conversion rate, higher liquidity and has lower financial risk. Finally, RHT has better sentiment signals based on short interest.