Old School Value

As you know, I try to approach stock analysis and business valuation with different methods in order to try and fill holes and weaknesses.

One aspect that I want to cover that I haven’t discussed before is regarding maintenance capital expenditures in Free Cash Flow (FCF) for the Discounted Cash Flow (DCF) valuation method.

Even now when it comes to FCF, I don’t worry about trying to calculate the exact details of maintenance capex, but going the extra mile to calculate maintenance capital expenditure will surely put you ahead of everyone else when it comes to uncovering hidden value.

Free Cash Flow Quick Recap

Free cash flow is the money generated that is not required to maintain operations. Simply, it is money that the business can use for whatever it wants. It can put it in the bank, give it to charity, pay a dividend, buy back shares or use it for future growth.

So when we use the simple version of the FCF formula

FCF = Net Cash from Operations - capital expenditures

we are calculating FCF by subtracting both the capital expenditure that is used to maintain operations and to fuel future growth.

(I am not talking about owner earnings here. Just the textbook FCF definition)

So in order to get an accurate FCF figure, the correct method would be to subtract ONLY the capital expenditure used to maintain the business.

What is Growth and Maintenance Capital Expenditure?

As outlined above, maintenance capex is the money that is required to maintain or replace assets.

e.g. A typically high capex company such as oil drillers are required to service its rigs and replace parts just to stay in business.

Free Cash Flow attempts to differentiate between growth and maintenance but it is rare for companies to disclose what is used for maintenance and growth in their statements, nor is it required. This makes finding maintenance capex a difficult task.

Before I go on, let me say that finding maintenance capex is definitely an art. There is no strict formula or method and I have yet to come across a firm process to date.

If you have know of a better way, please leave a comment at the end.

How to Calculate Maintenance Capital Expenditures

The common method is to assume

Maintenance Cap Ex = Depreciation and Amortization

therefore

Free Cash Flow = Net Cash from Operations - D&A

The train of thought is that buildings and equipment will need to be replaced in the future and because depreciation is usually a straight line approach, it will also be much smoother.

By looking at several years of data, a capex number that is stable yet does not lead to increased revenues is a sign that it is mostly maintenance capex.

Determining Maintenance Cap Ex

Let’s look at the difference between three companies, JNJ, WMT and ATW. I chose these three companies as I figured their capex requirements would vary.

My reasoning is that JNJ should have lower capex since their intellectual property and patents equates to a low maintenance capex, such like MSFT. They also sell their products distribution channels which should also keep the maintenance capex down.

WMT owns and leases their stores, is required to purchase more inventory in their existing stores.

ATW is a heavy growth and capex company as it is a deep sea oil driller which requires an extensive amount of capital and credit for maintenance and growth.

in $mil		2005	2006	2007	2008
JNJ	Revenues	$ 50,514	$ 53,324	$ 61,095	$ 63,747
	D&A	$ 2,093	$ 2,177	$ 2,777	$ 2,832
	Capex	$ 2,632	$ 2,666	$ 2,942	$ 3,066
WMT	Revenues	$ 312,427	$ 348,650	$ 374,526	$ 405,607
	D&A	$ 4,717	$ 5,459	$ 6,317	$ 6,739
	Capex	$ 14,563	$ 15,666	$ 14,937	$ 11,499
ATW	Revenues	$ 176	$ 276	$ 403	$ 527
	D&A	$ 27	$ 26	$ 34	$ 25
	Capex	$ 26	$ 79	$ 91	$ 328

So from the above number what do you see?

Notice how a non capex heavy,  stable cash cow business such as JNJ has D&A roughly similar to capex? JNJ has a very steady and minor increment in capex which also leads to a slow yet steady growth in revenues.

WMT is also similar. In 2008 we can estimate that their maintenance capex was $6,739m (D&A) which means that $4,760m was used for growth.

Lastly, we see that ATW has a fairly stable depreciation yet their capex growth is exponential. Now this is a sure sign of investing in growth and if you read and listen to the conference calls, they are building new and better rigs to add to their fleet.

Using depreciation and amortization as maintenance capital expenditure is also useful for when capex is erratic and FCF inconsistent, which is usually the case for companies like ATW and other industrial commodity businesses.

Another alternative is to normalize the capex or free cash flow, whichever is  easiest and then used the normalized number as the beginning point to your present value formula in the DCF valuation.

Bruce Greenwald also has a approach which I will get to in another post once I finish reading his book.

Disclosure

I own ATW at the time of writing

Stock Valuation Methods

Buffett and other respected investors mention that if you need a spreadsheet to determine a fair value of a company, the investment idea should be thrown into the pass pile. I only agree to some degree on this comment. It’s true that we should concentrating on no brainer investments rather than deworsifying into extra positions just for the sake of being invested, and while most people can read the financial statements to some degree, I’m sure many have trouble grasping all the numbers and coming up with a single dollar value as a fair intrinsic value number.

For me, as I run through companies, I always look at the free cash flow and cash flow statement first to determine whether the business is worth investigating. I can’t immediately come up with a number but I can determine whether the business is a good one. The investment spreadsheets you find on this site was created to determine whether these stock ideas are cheap and to determine the buy and sell price range.

So far I use the following stock valuation methods:

• Discounted Cash Flow (DCF)
• Ben Graham Formula using normalized earnings
• Ben Graham Net Net Working Capital
• Multiple methods based on industry and competitors (used occasionally)

Disadvantages of Stock Valuation Methods

Discounted Cash Flow

• Need to estimate a growth rate. (Be conservative)
• Need to project into the future
• Does not work well for young, growth or cyclical businesses

Ben Graham Formula

• Uses earnings which can always be inflated even if it is normalized
• Projects using a EPS growth rate
• Back tests have shown that the value is the upper range and overly optimistic

Ben Graham Net Net Formula

• Calculates the value of assets only
• Does not provide an upper range indicator
• A snapshot valuation method

Multiples Valuation

• Useless if business has no direct competitors (e.g. Mead Johnson Nutritionals. I’m having quite a difficult time trying to determine the fair value of the business.)

Earnings Power Value (EPV)

So even with 4 analysis tools in my toolkit, there is a hole that needs to be filled. Currently, I am still unable to value companies that are:

• young (<5 year old)
• cyclical
• no competitors
• growth

This is where I believe Bruce Greenwald’s EPV method will come in handy. The stock valuation method allows the investor to value all of the above points.

I don’t fully understand the details yet or how to derive the numbers but I’m reading and studying to see how I can apply it and convert it to a spreadsheet. In the meantime, I was able to find Greenwald’s lecture notes from Columbia business school on the investment process and valuation which I’m sure you will all benefit from.

The EPV section starts from slide 16.

Greenwald Earnings Power Value EPV lecture slides

Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is a popular measure used by many investors and analysts today in valuing the profitability and cash flow of the businesses. I personally have never used EBITDA and don’t plan to for its inferior nature. Let me explain why I believe EBITDA to be fairly useless measure of cash flow when trying to value a business.

EBITDA History

EBITDA became popular in the 1980’s with the boom of Leveraged Buyout (LBO) activity. At that time, EBITDA was more relevant because the criteria of the deals typically excluded companies that required substantial cash investment for capital expenditures, R&D or inventory.

The use of EBITDA became popular in industries with expensive assets that had to be written down over long periods of time and has remained popular as a tool in determining purchase price multiples and analysts use it regularly in acquisition pricing and analysis.

EBITDA Definition

EBITDA = Revenue - Expenses (excl. tax, interest, depreciation & amortization)

As you can see, the definition of EBITDA factors out interest, taxes, depreciation and amortization. This can make even completely unprofitable businesses appear profitable and is also easily susceptible to fraudulent accounting. Many companies include EBITDA and refer to it as though it represents cash earnings since depreciation and amortization are non cash expenses. This is a common misconception. EBITDA does not represents cash earnings. EBITDA is a good metric to evaluate profitability, but not cash flow.

Not to mention that EBITDA also leaves out the cash required to fund capital expenditure, which is critical for any business.

The Lemonade Stand

A 10 year old kid wants to open up shop with the coming summer season and because he has no money, he is being funded by this parents. $50 comes his way for a cheap table, cups, pitcher, lemons and tip jar. At the end of the day, the parents want to know how much money was made. How does the 10 year old businessman reply? Does he quote an amount that is adjusted for tax, interest, and D&A?

EBITDA does seem quite ridiculous when we simplify (maybe oversimplified) it to an easy to understand example.

Free Cash Flow Instead of EBITDA

Rather than using EBITDA to try and measure profitability or cash flow, the better way would be to use cash flow from operations from the Statement of Cash Flows or free cash flow which is what I use when analyzing and valuating businesses.

Summary

• EBITDA gives the appearance of more cash than there actually is by leaving out so many expenses
• Neglects cash required for working capital
• Neglects debt payments and other fixed expenses
• Neglects capital expenditure
• EBITDA is NOT cash flow
• Since EBITDA is a gross earnings base, it is a large profit metric and makes multiples seem smaller which in turn is a poor choice for making price multiple comparisons.
• Investors should focus on other performance measures to make sure the company is not trying to hide something with EBITDA

Everybody has a method of researching and analyzing companies. Whether we abide to our own set rules or not, the more important point is that we have a process that we adhere to. Whether you day trade, look at technicals or do it mechanically, a process which you can follow and continually improve is a definite requirement.

The following is a process I (usually) stick to except for special situations such as arbitrage, spinoffs and net nets.

Finding Investment Ideas

There are many sources of finding investment ideas. Ideas may come from the following:

• screens
• blogs and quality sites
• newspapers
• books
• magazines
• performing everyday duties (Smuckers, Midas, Safeway etc)

I’ve previously written about ways to find ideas.

Rundown of the Business

Once I’ve found a company of interest, I perform the following actions and try to answer a series of questions.

• What does the company do?
• Go through the latest 10-Q or 10-K statement and quickly review the financial statements. Can determine whether to pass or go on after 30sec -1 min.
  
• Quickly estimate an intrinsic value via DCF, Graham, PE, NNWC methods to get an idea of the buy price range

If the above information leans towards a favorable investment, the next step is to read up on the company.

Researching the Business

• Competitive advantage (moat) to determine whether it is a short term, mid term or long term investment
• Management (compensation, company perks, previous performance)
• Business model
• Strategy compared to competitors
• Growth (I don’t place a heavy emphasis on growth)
• Risk (the company knows its risk better than anyone. 10-k’s provide a detailed list)

At this point, I know what the company does and how it intends to go about do it. The next step is to see whether they are doing it properly.

Analyzing the Business

• Detailed look at the financial statements line by line for the past 2 or 3 years of 10-K filings and then 10 years with the spreadsheet)
  • View how to analyze a business via the income statement, balance sheet and statement of cash flows.
  • You can tell whether management do what they say by analyzing the margins and other performance metrics such as CROIC, FCF, ROE.
• Competitor numbers (compare with spreadsheet)
• Come up with a buy price with conservative and realistic figures

Management can always talk the talk, but the numbers prove whether they have been walking it as well.

Psychological Questions

I’ve recently added a psychological section after some recent bad mistakes. I must admit this is by far the hardest section to answer but one has to be brutally honest.

• Am I giving more weight to recent data and events?
• Did I think a fact was obvious beforehand?
• Have I looked at the situation from different scenarios? (Company loses money, no growth, growth etc)
• Am I influenced by the way the data is presented preventing me to perform the required work?
• Am I overconfident in the analysis because I work in the industry or otherwise?
• Have I reviewed the negative factors?
• Am I over-weighing the negative factors creating too much loss aversion?
• Am I buying just to average down?
• Am I slow in changing my opinion?
• Am I ignoring potential risks because of the reward?
• Am I willing to purchase because I spent the time researching? Obligated to buy?
• Is there a bias because everyone else is recommending to buy?
• Am I refusing to sell for any reason? Attached?
• Is the information I am using a consensus that can be false?
• Do I have an exit plan?

How Much Data?

• 10 years of statements from spreadsheet to get an idea
• Detailed reading of annual reports - 2 or 3 years worth. Mostly going through the risks and management discussions and footnotes.
• Quarterly Reports - 1 or 2 quarters. Looking for any new changes. e.g. off balance sheet obligations, footnotes.
• Latest Proxy - looking at compensation, stock options, the board members, company perks such as jets or cruise ships.

(This post was first published on The DIV-Net)

Let’s face it, there are some companies in our portfolio where we bought without completing our due diligence. Maybe Cramer was too convincing or your friend’s rationale was logical at the time, but ultimately, it’s our money and we only have ourselves to blame if something goes wrong.

To start remedying this situation, here is a list of red flags from Business Journalism that should raise concerns should you find your company following these points.

Many of these points have been raised in the book The Art of Short Selling which I wrote about here.

Red Flags for Investors

• When a company starts bashing short sellers.
• When you read the SEC filings and still can’t seem to understand what’s going on.
• When you see lots of new footnotes and disclosures, particularly of things that happened years ago.
• When companies count revenue when items are simply shipped, or they are using a percentage-of-completion method.
• When there are big gaps between numbers in the press release and in the 10-K/10-Q. Regulation G makes this harder for companies to do today, but it still happens.
• When companies seem to take special charges/gains, quarter after quarter and year after year.
• When there are lots of related party transactions with officers and directors. Just because the transaction seems small, don’t dismiss it as being insignificant.
• When publicly traded companies are still run like family businesses.
• When there are lucrative consulting contracts/severance agreements with current and/or former directors and executives.
• When there are big increases in director’s fees or perks.
• When there’s an inattentive audit committee.
• When there’s a sizable increase in non-audit fees paid to the accounting firm.
• When the interest rate return on pension fund seems unusually high, or when 20 percent or more of operating income comes from pensions
• When there are off-balance sheet obligations that had not been previously disclosed.
• When you see the words “formal” or “informal investigation,” “subpoena” or “Wells notice.”
• When there are unusual income tax rates – either unusually low or unusually high. Rates should fall between 30 percent and 40 percent.

View the full PDF here which also includes examples.

So far, we’ve had a look at the Statement of Cash Flows with AeroGrow with a further discussion on Free Cash Flow, Croc’s Income Statement and now the Balance Sheet for Circuit City.

To help get new investors started, here are some great resources on the Balance Sheet:

1. Fundamental Analysis: The Balance Sheet
2. Understanding the Balance Sheet

Circuit City Balance Sheet (click to enlarge)

Cash

Any company with lots of cash is a reassurance to investors that the company should be able to survive during downturns as well as expand during booms.

Divide the cash by the number of shares outstanding to see how much of the stock price is made of cash. On Feb 29, 2008, Circuit City had $1.76 in cash per share but by August 31, 2008, that number dropped to $0.54 and has probably dropped further since then.

If the cash per share is greater than the share price, it could be a potential net net.

Accounts Receivables

As I covered in the Statement of Cash Flows, accounts receivables is an indication of whether the company is able to collect its payments. If accounts receivables decrease from the previous years (you have to compare by going back a few years), the company  has been able to collect its money.

If this is continually increasing, the company is either willing to sell to anyone or the company may have become lenient in its payment policies to customers which could lead to an inflation of earnings causing nasty surprises later on.

Compare the increase in accounts receivable with increase in sales. e.g. If accounts receivables has increased 120% while sales only increased 90%, the company is not collecting bills.

I’ve only displayed a quarterly statement for Circuit City but if we look back at the previous statements, Circuit City has been unsuccessful in reducing this line. Although the sum of $330mil is a good reduction from $447mil in Nov 2007, the overall story shows that Circuit City has an unimpressive payment collection system.

Inventory

One of the most important aspects of the balance sheet. Ben Graham has written that inventory should be marked down to 50% of its valuation when calculating a liquidating value. This is true especially when it comes to electronics. With a product life cycle lasting only a few months, old inventory will continually have to be discounted.

Inventory should also be compared with cost of goods. This inventory indicator is a reliable sign of whether a manufacturer or retail company will stumble if the difference is substantial. In terms of inventory growth, Circuit City hasn’t done too bad of a job but their inventory level is far too high for a business of their size.

It’s also a good idea to compare the inventory turnover with competitors. While Best Buy has been able to turn over its inventory 6.9x times a year for the past 5 years while Circuit City has only managed an average of 5.5x in the past 5 years.

A further discussion of inventory will be required in another post as we look at how companies calculate and state the value of inventory.

One Time Items

Deferred income taxes and income tax receivables should not be considered as part of business assets. They add no value to the operations of the business. Hopefully these numbers are kept low and not included too often. Circuit City needs all the cash it can get. It shouldn’t be overpaying taxes and waiting to receive it without interest from the government.

PP&E and Goodwill

PP&E is an illiquid asset and is mostly taken into consideration when the company is liquidating.

If the company owns land, additional research would be to find todays market value of the land.

As most readers know, goodwill is best ignored. No tangible value exists and impairment charges usually always appear from a goodwill that is too high.

Although Circuit City “may” have a brand, I believe there is no tangible value because there is nothing stopping a consumer from crossing the road to Best Buy if they have better prices.

Liabilities

Liabilities is much like the assets section. There are payments that have to be made and if this number increases, the company has not been paying their bills.

Circuit City’s problem is that they are overladen with debt and no cash. They need to pay suppliers in excess of $750 mil, expenses in the amount of $270 mil and $343 mil for accrued expenses and other liabilities as well as a short term debt of $215 mil due shortly. With only $91 mil in cash and the rest tied up in inventory, no wonder the suppliers demanded cash up front for delivery of items.

Also, watch out for companies like Circuit City that have accrued so many expenses. These are obligations that must be paid which will hit earnings hard.

Circuit City has also been deferring its rent credits. Companies often abuse deferred charges by pushing expenses into the future so that they can inflate earnings even when things are not going so great.

Circuit City’s “other” liabilities add up to over $150 mil so its always important to check the footnotes as well as the possibility of off balance sheet liabilities.

Quality of assets

Quality of assets is something you should always be asking yourself whenever going through a balance sheet. Circuit City’s assets are made up of mostly inventory, property and equipment. However, we know that electronics cant hold their value for more than a few months and Circuit City does not own their stores (land). So all the stated property and equipment is probably associated to shelves, tables and other shop fitting items. Nothing that can fetch full value.

Quality of assets for Circuit City? BAD

Summing Up

• Cash helps companies survive and grow.
• Watch the trend in Accounts Receivables. Be careful of companies unable to collect money.
• Take the value of inventory stated on the balance sheet with a grain of salt. Different accounting methods (FIFO, LIFO) produce different ending values even though the products are the same.
• One time items in assets should appear often such as sale of assets.
• PP&E is illiquid and should be considered mostly in asset plays or liquidation. Ignore goodwill.
• All debt isn’t bad. Just when you can’t afford it.
• Assets should be high quality (cash is best)