What Drives Operating Metrics? Simple Things I Forget (#investing, #finance)

A few weeks ago I was looking over the Morningstar.com tearsheets for about forty different mid-to-large-cap companies on a small assignment for an acquaintance. The project involved looking at the major financial metrics for a number of companies as provided on these tear sheets and trying to develop a quick, summary opinion of their business performance over the last decade.

On the one hand, it was just a bunch of series of numbers, going up, going down, sometimes not going much of anywhere at all. Depending on the metric being examined, this might be good, bad or ugly. But, if you looked a little closer, you might realize that even these simple numbers could tell a larger story about the business and what was happening to it or with it over time. You see, every financial metric I looked at was merely the result of the interplay of two, three, four or more other numbers “beneath” it. As one or some of these numbers changed, so, too, did the “top level” metric I was looking at on the tearsheet.

I spent a considerable amount of time, specifically, looking at the income and cash flow metrics, the reason being that most of these were large, stable and often growing enterprises– the balance sheet is always useful but with these kinds of companies what happens to income and cash flows over time can be an even more exciting and compelling story.

When analyzing an income statement, there are three key profit measures that investors like to look at: gross, operating and net profits. Additionally, when examining the balance sheet for the cash generating abilities of the business, there are two key measures investors focus on: operating and free cash flows.

If you’re like me, you sometimes forget the simple relationships these metrics have with other financial statement figures in terms of how one number drives another. Or maybe you’re new to studying financial statements and are looking for a handy reference. Either way, the following information may be helpful for you.

Let’s start with the income statement metrics:

  • Gross Profit, equal to total revenues minus the costs of goods sold; because of this, higher gross profits are arrived at by either increasing the price at which goods are sold (making revenues larger) or decreasing the costs of the goods sold (making COGS smaller)
  • Operating Profit, equal to gross profit minus the expenses incurred in running the business, such as paying sales costs (marketing, advertising, commissions), employees salaries and bonuses and corporate administration (SG&A), using PP&E and incurring depreciation or amortization expense and any costs related to the development of new products and services (R&D); because of this, higher operating profits can be achieved by lowering R&D expenses, lowering SG&A expenses, lowering D&A expense or raising gross profits by one of the methods discussed previously
  • Net Profit, equal to operating profit minus interest expense and tax liability; because of this, higher net profits can be achieved by minimizing tax expenses, reducing financial leverage and the interest burden that comes with it (or by refinancing existing debt at a lower rate), or raising operating profit by one of the methods discussed previously

If you are examining a series of income results for a company over a period of years and notice a variance in any of these primary profit metrics, look to the component drivers of those metrics to help explain the reason for the variance.

Now let’s take a look at the two cash flow items:

  • Operating Cash Flow, equal to net income plus the addition of all non-cash expenses (such as depreciation and amortization) and the net change in working capital; increases in operating liabilities increase operating cash flow, increases in operating assets decrease operating cash flow, higher D&A charges increase operating cash flow and of course, a higher starting net income increases ultimate operating cash flow
  • Free Cash Flow, equal to operating cash flow minus total capital expenditures; the less the company invests in maintenance and growth expenditures of capital now, the higher free cash flow will be, but if not enough is spent to protect the business’s earnings power and market position, long-term free cash flow generation abilities may become impaired

The operating cash flow metric is important to look at because it tells you whether the company actually generates a positive cash return on its investments from its main business activities. Companies that can’t generate cash from their operations over time are destined to financial and economic failure. Changes in operating cash flow when compared to changes in net earnings can give a window into how the company is generating profit– through business and market management, or through accounting manipulation and trickery.

The free cash flow metric is valuable because it shows the resources the company generates, beyond those needed to grow and maintain its current capital investments, which can be used to reduce indebtedness or reward shareholders with buybacks and dividends. Companies with relatively high and sustainable free cash flow-generating characteristics can be rewarding investments over long periods of time if they can be bought at low multiples to their normalized free cash flow.

There is a lot more to financial analysis than this. There are hundreds of ratios, metrics and other financial data you can use to measure the operating efficiency and management talent of companies you are interested in. This is not meant to be a comprehensive review. It’s possible I even missed a few items of note with regards to the metrics I singled out.

But sometimes I forget these simple truths when trying to think deeply about businesses I am analyzing, so I wanted to leave this little note for myself in case I ever get stuck and forget the obvious again. With any luck, this information will help someone else out in a similar fix, or else it will prove to be a stepping stone for a beginner making their first inquiry into the world of business analysis.

Notes – A Compilation Of Ideas On Investing (@geoffgannon, #ncav, #netnet, #valueinvesting)

Why I’d Never Pay More Than Book Value For Nokia

  • You hate to see a group of the top five companies of an industry where they entered the industry at different times; this implies companies are coming and going as they please
  • You want the company you’re looking at to have a relatively high market share, ie, the company’s market share divided by the next closest competitor is high (1.5+)
  • The first line of defense in competitive environments is having the most customers relative to the alternatives; being the preferred product
  • As long as you believe a company’s competitive positions are lasting, you can buy the stock on a P/E basis

Ben Graham Net-Nets That Don’t File With The SEC

  • The simplest way to separate safe net-nets from unsafe net-nets is the number of consecutive years of profits
  • Profitable net-nets seem to be especially common candidates for abandoning the responsibilities of a public company without actually getting taken private
  • If you can’t trust the controlling family, you can’t trust the auditors

Free Cash Flow Isn’t Everything

  • Buffett-style approximation of unleveraged return on tangible equity: EBIT/(Receivables + Inventory + PPE) – (Accounts Payable + Accrued Expenses)
  • This represents the net investment; in the example of WMT, it represents their ability to finance $50B in productive assets at 0% interest
  • Reinvestment in businesses with sustainable double-digit ROIs is superior to receiving dividends (thanks to higher FCF)
  • It is harder to find companies who can earn high returns on unlevered equity and increase the size of that tangible equity over time than it is to find companies who can earn high returns on unleveraged tangible equity
  • For looking at return on invested tangible assets: EBITDA/(Receivables + Inventory + PPE) – (Accounts Payable + Accrued Expenses)
    • then, go back 15-20 years and find range, median, etc.
    • examine how much tends to be converted to net income or FCF to get an idea of profitability
  • FCF != Owner’s Earnings; only counting the cash available after a company grows will result in you passing up many good, growing businesses simply because they’re growing
  • If a company is earning good returns on their investments, it’s okay for them to not produce a lot of FCF
  • Businesses you’re investing in for profitable future growth should be 150% of the growth you think you could provide with another use of the money; the 50% represents margin of safety in your future compounding
  • Over time, more reliable returns compound better than less reliable returns
  • The most reliable ROIs tend to be in businesses built around a habit
  • Habits are the first line of defense in a business
  • The best business defenses involve:
    • defending specific customers
    • defending specific locations
    • defending specific times
  • Buffetts favorites are business which:
    • have pricing power
    • have the lowest costs (can operate profitably at margins competitors can not)
  • Your return in a good business, held forever, depends on:
    • Growth; what quantity of earnings are you purchasing today?
    • ROI; how much room is there for reinvesting those earnings in the future?
    • Earnings yield; what will you earn on those reinvested earnings?

Earnings Yield or Free Cash Flow Yield: Which Should You Use?

  • Look to the story of Hetty Green; don’t put more into an asset unless the return you can get from that addition is better than what you could get elsewhere
  • A company that grows value doesn’t have to pay anything out; with real Owner’s Earnings, no FCF is necessary
  • FCF is useful for determining how much money is available for:
    • Dividends
    • Stock buybacks
    • Debt repayment
    • Acquisitions
  • In this case, use FCF/Market Cap to determine your “equity coupon”
  • Owner’s Earnings is useful for determining: How much bigger will my snowball get this year?
  • OE are just as valuable as FCF if and only if the future return on retained earnings is comparable to the average of the past; the wider the moat, the more reliable the historical average is
  • If you think you can earn 10% in your brokerage account:
    • a company earning 12% unlevered returns on tangible net assets is probably a wash and it’d be better if they gave them to you
    • but a company earning 20% is a different beast altogether– you’re probably better off letting them compound your money for you
  • If you know ROI will stay above what you could achieve yourself, use a P/E type measure (or EV/EBIT or EV/EBITDA, depending on accounting) to price the stock, don’t use FCF
  • Valuing businesses by ROI:
    • By earnings; reliably above average returns on investment
    • By FCF; consistent companies with a mixed or impossible to evaluate ROI situation
    • By tangible book; inconsistent companies with an unreliable or poor ROI situation
  • Stated another way:
    • Good, reliable companies are snowballs; worth what it can grow as it travels downhill; dynamic
    • Mixed, reliable companies are waterfalls; worth the rate of its flow; constant
    • Unreliable, bad companies are rocks; worth its weight; static
  • Remember– assets produce earnings; earnings become assets; the process repeats
  • Ask yourself:
    • What is the sustainable rate of cash removable from the business?
    • What is the value added or subtracted from the business by the resource use decisions of management?
  • Assume that retained earnings at subpar businesses to be worth less than their stated amount; similarly, retained earnings at above average businesses are worth every penny
  • With great businesses with favorable long-term prospects, treat earnings as FCF; it’s fine to use the earnings yield
  • Never make the mistake of thinking depreciation is a provision for the future; it’s a spreading out of the past
  • At bad businesses, cash is worth much more than inventory, receivables, property, etc.; in these cases, don’t use earnings yield, use FCF yield and asset value

How To Analyze Net-Nets Undergoing Change

  • As part of a group, you can easily invest in businesses undergoing change
  • “Managers rarely rush to evacuate excess capital from a sinking ship. Usually, they’re still there trying to save the wreck.”
  • It’s generally better to invest in a corporation undergoing change than a business undergoing change
  • With changing customer habits, it can be nearly impossible to predict future earnings
  • I require at least ten years of history before investing in a company for any reason other than its cash; prefer 15-20 years of history whenever possible
  • Overcapitalized companies undergoing change are good stocks to follow
  • Worldwide, there are fewer investors looking at Swedish stocks than US stocks; that’s an advantage if you’re looking at Swedish stocks, so use it

What Broker To Use When Buying International Stocks (Gannon On Investing)

  • Geoff uses a full service broker, but recommends Interactive Brokers or Noble Trading for most others looking to buy foreign stocks
  • If going with a full service shop:
    • personally know a broker ahead of time
    • give him your account with a clear understanding of what it is you want to do; try to negotiate a flat, guaranteed commission structure so you know how much it’ll cost you and he knows you’re worth the trouble
    • a good rule of thumb is 1% per roundtrip trade; it’d be greedy for the broker to ask for more than 2%
  • If a broker promised me it could buy any stock anywhere in the world for 2% of my assets per year, I’d take that deal
  • I look at my cost in a stock on an after-commission basis
  • “My broker won’t let me buy that stock” is never a valid excuse; if the broker won’t buy the stock, get a new broker
  • “Ben Graham said investing is most intelligent when it’s most businesslike. Business often means work”
  • Never let anything get in the way of buying the best bargains, especially not your broker

How To Find Cheap Foreign Stocks

  • Online research process for finding foreign stocks:
    • Screen for stocks in specific countries using the FT Screener
    • Check the business description, EV/EBITDA, etc., at Bloomberg
    • Look at the 10-year financial history at MSN Money
    • Go to the company’s website and read their annual reports
  • Bloomberg has the best worldwide coverage of stocks in their database
  • A good screen to start with at FT.com is a single digit P/E screen– just scoop up the simplest, most obvious bargains
  • Many European companies that aren’t too tiny trade in Germany
  • Use Google Translate if you’re having language issues
  • Beware of accounting differences:
    • US uses GAAP; insists on historical cost and does not permit revaluation of non-financial assets; in general, old US companies with lots of land and inventory (using LIFO) are more likely to contain “hidden assets”
    • RoW uses IFRS; PPE and investment property less likely to be carried on balance sheet at extremely low stated value; different way of valuing biological assets; never uses LIFO accounting for inventory; less likely to mask an asset’s liquidation value than GAAP
  • Good screen in the US due to GAAP accounting for depreciation: (Accumulated Depreciation /Tangible Book Value) * (Tangible Book Value/Market Cap) > 1; shows you the cheapest stocks relative to what a competitor would pay to own their assets; produces a real Ben Graham-type list
    • should also add: Tangible Book Value > Total Liabilities
    • and: Net Income > 0
  • Due to accounting differences, if you’re new to international investing, focus on earnings bargains, not asset bargains
    • It’s okay to buy companies that are cheap P/B if they have 10 yrs of consistent earnings
    • Otherwise, stick to low P/10yr avg earnings
  • Low EV/EBITDA is good to use around the world as it erases some differences in accounting
  • Good UK-specific screener– SharelockHolmes

How To Find Foreign Stocks: 13 Promising Companies From The U.K. (Gannon On Investing)

  • I went to the London Stock Exchange website; then I browsed stocks alphabetically
  • I was looking for potentially promising companies, regardless of price
  • In other countries, I start by looking for good businesses I can understand; the bar is higher overseas
  • Use the following process for finding promising companies:
    • At the LSE website:
      • clicked “fundamentals” tab
      • scrolled down to ROIC
      • looked for positive number in the double-digits
      • 20%+ ROIC over the last few years
    • Look the company up in Bloomberg
      • If you can’t understand the business description, throw it out
      • If it sounds like it has the potential to earn very high returns on capital, proceed
    • Looked up the annual report’s cash flow statement
      • CFO > CAPEX in each of the last several years
      • ie, should be generating FCF
    • For all the companies that qualify, download the past annual reports into a folder on desktop
    • Start reading annual reports from oldest to most recent
    • Then, appraise the value of the company, ideally without looking at the price first
      • 10x normal EBIT
      • 15x normal FCF
      • if the company is trading at least 25% below the value you appraised it at and you love the business, consider buying
  • Searching alphabetically is an old school, Buffett way of stock research
  • “Having to form your own opinions from scratch does wonders for investment analysis”; searching from scratch puts you in the best mindset to value a stock objectively
  • Three dependable ways to turn up great stock ideas:
    • Go through a list from A to Z
    • Read value investing blogs
    • Direct, personal experience with the company
  • Good UK value investing blogs:
  • “My best investments come from stocks I study and pass on due to price, only to buy the same stock some 4 or 5 years later when it has its Salad Oil Scandal moment”

5 Japanese Net-Nets: And How To Analyze Them

  • Net-net investing worked in actual practice in the 1930s and 1940s in the US; Japan is similar, but worse
  • Price and value determine your returns based on four factors:
    • Earnings yield (price)
    • ROI (profitability)
    • Sales growth (growth)
    • Dividend yield (dividends)
  • The lower the yield on the stock, the higher its earnings yield, growth and ROI need to be to justify investment
  • Japan is experiencing deflation of -0.7% while the US is experiencing inflation of 2.9% so you need to add 3.6% to all Japanese yields to get the equivalent in real terms in the US
  • A company’s real dividend yield is effectively a reduction in your hurdle rate
  • Japan is a low/no growth economy, so it makes sense to pay out earnings as dividends or retain them as cash rather than tie them up in low-return, long-term investments such as PPE
  • The margin of safety in Japanese net-nets is that the dividend yield is a payback unrelated to ROI
  • With Japanese net-nets, you exchange low growth and low ROI for high dividend yields, deflation (rising cash value) and excess cash
  • Japanese net-nets offer P/E around 10, dividend yield around 3% and net cash close to market cap, meaning you get three bets:
    • the value of the stock’s future retained earnings stream
    • the value of the stock’s future dividend stream
    • the value of the stock’s future cash pile deployment
  • The biggest threat to Japanese net-nets is a decline in the value of the  yen; this is the best reason for passing on net-nets in Japan
  • “If half my money is in dollars and half is in something else and all 100% of my portfolio is in some of the cheapest stuff on earth– my results will be fine… over time”
  • The US in the 1930s is the best illustration of what net-net investing in Japan is like
  • “I prefer a lot of uncertain opportunities to make money over time to one seemingly certain exit strategy”
  • The quality of net-nets in the US is not as good as in Japan; most US net-nets are extremely unsafe; this is a consequence of a few good years in the stock market