Is Abbott Laboratories a good stock to buy?

— -- Q: Is Abbott Laboratories a good stock to be holding in this economy?

As a maker of health care products sold worldwide, Abbott Labs is an example of a company in a so-called defensive industry. Unlike other products, which consumers and businesses can put off buying until times are better, if you're sick, you must go to the doctor. And most likely, your doctor will consume medical equipment while treating you.

Furthermore, by selling goods around the world, the company is somewhat geographically diversified. So if the European economy continues to sputter, Abbott may continue to see decent demand in other nations. During the third quarter of 2011, 58% of the company's revenue came from outside the U.S.

But if the company is so diversified and in a "defensive" industry, why aren't its earnings reflecting better results during the economic weakness? During the third quarter, Abbott's net income sank 66% to $303 million, despite a 13.2% rise in revenue to $9.8 billion.

It turns out, that a large reason behind the decline in net income is the creation of a $1.5 billion litigation reserve connected with a previously disclosed investigation by the U.S. Department of Justice. The DOJ is investigating whether drug companies have inflated the price of drugs.

Given all the characteristics of the company, does Abbott belong in your portfolio? To find out, we'll put the stock through the four tests considered at Ask Matt, including:

Step 1: Risk vs. reward. When you take a risk on a stock, you want to make sure you're properly rewarded. Downloading Abbott's trading history back to 1984, we see the company generated an annual compound rate of return of 0.7%. Adding the current dividend yield of 3.7%, that means Abbott generated an average annual compounded growth rate of 4.4%. That's a pretty low return if you consider the S&P 500 returned an annualized 11.8% return over the same period, says IFA.com.

And to get that low return, you had to take much greater risk. You accepted risk — standard deviation — of 27 percentage points. So, by investing in Abbott, you took on 64% more risk to get a 63% lower return. Greater risk for less return, is usually not a good tradeoff.

Step 2: Measure the stock's discounted cash flow. Some investors decide if a stock is pricey by comparing its current price to the present value of its expected cash flows. It's a complicated analysis made simple with a system from NewConstructs.

When we run Abbott's stock, we find it's rated "neutral." In other words, the current stock price is roughly equal to the value of what the company is expected to generate in cash over its lifetime. NewConstructs charges for its reports, but a free Abbott report is available to Ask Matt readers.

Step 3: Compare the stock's current valuation to its historical range. BetterInvesting's Stock Selection Guide can help. If the company can increase earnings 10.8% a year the next five years, that would put the stock in the "buy" range. This indicates the stock is inexpensive relative to the earnings the company is expected to generate.