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Archive for March 2010

PFE and Calculating Sustainable Growth of ROE

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Never let it be said that, in this journal of my investing life, I was not prepared to describe my mistakes.

I am, in fact, thinking of Pfizer, which I purchased at $25.46 and $22.96 on March 9, 2007 and February 26, 2008, respectively, for an average price of $24.00.  Today, the stock is selling for $17.39 — down around 28%.  At the time, it seemed a reasonable purchase (they all do), selling cheaply based on discounted cash flows.

The problem was that, while I teach healthcare management, that doesn’t make me qualified to assess the strength of pharmaceutical products or their pipeline of compounds undergoing research and development.

In short, this stock should have gone into my Too-Hard pile … but it didn’t.  In fact, even if my resume included the earned-degrees PharmD and bio-physics Ph.d., I doubt pharmaceutical firms creating patent-protected medications would ever emerge from the Too-Hard box.

Today, the stock is undervalued based on DCF (Discounted Cash Flows).  With Lipitor’s expiration looming and the pipeline unimpressive to the market, DCF indicates the stock is undervalued by more than 60% — using a starting value of free cash flows of $15.3 billion, a free cash growth rate of 12.8% (the median of running three- and five-year medians over the past decade), a 5% growth rate for the second decade, a 15% present-value discount rate, and the current $95.56 billion in shareholder’s equity as the continuing value).

Even if basing DCF on Owner’s Earnings, rather than Free Cash Flows, and estimating future growth using sustainable ROE (i.e., normal ROE with dividends subtracted) the stock is selling at a 37.2% discount.

Lengthy Educational Aside That Delays Admission of Dufus Error In Judgment.

At this point, I should stop and, for the sake of explanation and reader education, describe something that hasn’t been put forward with prior postings — this education thing is, after all, one of the reasons for this blog (kind of a “look what I learned at camp” exercise).  Specifically, I should explain the concept of sustainable ROE (we will return to PFE as a mistake soon enough).

First, Return on Equity is defined by Investopedia as:

Return on Equity = Net Income/Shareholder’s Equity

Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder’s equity does not include preferred shares.

ROE can be broken out based on three and five measures, using the Dupont Breakdown. For the three-item version, we have:

Net Income/Sales
Sales/Total Assets
Total Assets/Equity

Note that the first two items are the components of Return on Assets, where Net Income/Sales is the company’s Profit Margin and Sales/Total Assets is the Asset Turnover rate. The third item, Total Assets/Equity, represents a measure of the company’s debt and is known as the Equity Multiplier. This means the difference between Return on Assets (ROA) and Return on Equity (ROE) is the multiplier effect of debt.

For Pfizer, we get:

Note that, when I first purchased the stock in 2007, debt was declining and the other two items were stable — even though the Asset Turnover measure was down from 2000.  Since then, the Equity Multiplier has increased while Asset Turnover has dropped yet again.

The other breakdown of ROE involves five items:

Tax Burden = Net_Income/Earnings Before Taxes

Interest Burden = Earnings_Before Taxes/Operating Income

Operating Profit = Operating Income/Revenue

Asset Turnover = Revenue/Total Assets

Leverage Ratio = Total Assets/Total Equity

Note that the Leverage Ratio line from this chart and the Equity Multiplier from the previous chart are the same, as is the Asset Turnover line.  To make this chart an even more confusing jumble of lines, I’ve added a sixth line for the ROE.

Now, lets turn to the calculation of the Sustainable Growth Rate, which is the rate of growth the company can, theoretically, generate without taking on new debt, securing  other capital financing, or delving into savings.  Let’s start with the general spreadsheet:

I should note that all dollar figures are in millions.

The portion of the spreadsheet that pertains to Sustainable Growth is this part:

The first thing we need to do is to determine the percentage of free cash flows not distributed as dividends.  The company, after all, can only deploy the cash it has available for deployment (before taxes).  So, we use the percent of free cash not distributed as dividends:

I’ve provided the calculations, which reads:  =IF(B17=0,0,1+(B16/B17)).  This is an if-then statement, where the first part forces a zero response if the denominator in the subsequent equation is zero.  The meat of the equation is:  1+(B16/B17).  This has the effect of identifying the percentage dividends paid out of free cash, which is then subtracted from 1 (100%).  In other words, this is the percentage of Free Cash Flows left over after dividends are paid.

Because dividends are taken from the Statement of Cash Flows, where dividends paid are always negative numbers, I add the negative percentage of dividends divided by free cash flows to 1 (100%).    I could have calculated this as  1-(-1*(B16/B17)), but that would have been less elegant (which is computer-geek-speak for “needlessly complex”).

The rest of this is really very straight forward.

Specifically, just multiply ROE by the percent of free cash retained by the company.

By the way, you can do the same for ROA, but, instead of Sustainable ROE, this is known as the Internal Growth Rate.  Why?  Well, recall that the difference between ROA and ROE is the equity multiplier … i.e., debt … and debt represents external capital financing.

Note that, for companies with absolutely no debt, ROE and ROA will be the same.  AND, for companies that pay no dividends, sustainable growth will be no different than ROE, just as internal growth will be no different than ROA when no dividends are paid.  In the case of Pfizer, there is a difference for both:

Recognizing this distinction between ROE and ROA, on the one hand, and Sustainable Growth and Internal Growth, on the other hand, is important.  It implies that ROA and ROE are important measures when trying to determine the benefits accruing to the stockholder.  But, if viewing ROA and ROE from the perspective of the company, Sustainable and Internal Growth are the better measures.

Personally, I am more concerned with the company’s future growth than with the dividends paid to me as the stockholder.  If the company can grow and generate results at rates greater than I can produce with other investments, that is my preference.

Indeed, most companies can more easily generate superior results because they have a headstart of between 15% and 35% (the tax hit I confront when selling the stock or receiving dividends).  In fact, the company’s head start is even more pronounced  because it can invest profits toward future growth before paying taxes on those profits.  Add to this the miracle of compounding, and that head start is so pronounced that I stand a snowball’s chance in hell if hoping to easily find a superior investment alternative when the market is fairly valued or over valued.  It is only if the company can not generate productive returns at rates exceeding the norm (net of my tax hit) that paying a dividend benefits me, as the stockholder.

This is a recognition that appears to befuddle many investors.  On the online message boards, someone is bound to argue that management should pay a dividend or increase the dividend or repurchase shares as a way to improve the stock’s price.  Rarely do they consider the tax implications of their urgings or the impact of share repurchases on the company’s profitability and growth prospects over time.

Even if I plan to sell the stock in a year or two, I want the company to think and plan for the long-term — to act as though none of its stockholders will ever sell.  Why?  Eventually, the market tends to give a premium value to those companies possessing substantial promise for decades to come, while, conversely, the market discounts the value of companies that manage their investments as if they are to be sold tomorrow.

This is different from the conventional wisdom, of course, but think about the price demanded for the strongest firms — those with the most consistent returns and strongest reputations.  The price of JNJ may decline short-term if posting less than consensus results, but the price is unlikely to tank to the same degree as for firms with less-reliable or suspect prospects.

On the other hand, it may be imagined that the stock will sell at a higher price if the market anticipates that the company is for sale — expecting that an acquiring firm will pay a premium of around 20% or more.  That 20%, however, is a pittance compared to the compounded growth that quality companies can generate when reinvesting profits to the benefit of the owners.  It is only when the company is unable to do this and has an excess of cash (more than it can productively use) that paying a dividend or repurchasing shares makes sense for the owner.

So, when I decide to sell a stock, I want the market to pay an exceedingly dear premium for my wisdom in selecting excellence, and I want to sell at a profit sufficient to compensate me for the tax hit and market risk.  Selling, therefore, at a 10% or 15% profit falls short of that mark, and, if the company is bought out at a 20% premium, that 20% is barely enough to compensate me as the owner, after factoring in the capital gains taxes, the market risks, and my subsequent obligation of finding another investment that can generate an adequate and reliable return on my investment.  Great investment ideas are not so plentiful that being bought out for a 20% gain makes we weep with joy.

Perhaps a different perspective will prove helpful.  If inflation is expected to run at around 4% or 5% over the coming decade (due to increased deficit spending by government) and yearly market risk comes in at 6.8 percent, my minimum required rate of return is around 12%.  Add to this the risks associated with opportunity costs (the risk that I won’t be able to find another opportunity), and that increases my required rate of return to somewhere between 15% and 17%, depending on whether the market under-, fairly-, or over-valued.  If receiving a 20% premium over the current market price for the stock (the price at which I could sell regardless of whether the company is bought by an acquiring firm), my gain is just 17% after taxes (assuming a 15% capital gains tax).

In other words, my required rate and the return received are the same — making me agnostic on the acquisition.  If my acquired company is truly excellent, my agnosticism turns to angst — which is how I felt when NOV acquired Grant Pride Co several years ago.  Grant (which I owned) was a wonderful company (the financial ratios and performance were clear on this), while NOV was bigger but not nearly as impressive.  To be fair, NOV paid a 30% premium for Grant, but Grant was so good that I couldn’t help wonder whether I was being under compensated.  And, when NOV’s stock shot-up after the deal went through, my suspicions seemed confirmed.  Pleasantly, the deal was a combination of cash and stock, so I benefited from my newly-received NOV shares (a lucky break that had nothing to do with my skill as an investor).

By the way, all of this is different from conventional value-investing, where the lion-share of price appreciation is derived from having bought at a discount on the front end.  Buffett, however, seems to hold this same perspective — given his penchant for buying and holding long-term, preferring companies with well-defined and defensible moats, and his willingness to pay a fair price for an excellent company.

Back to My Mistake With Pfizer

Of course, I started this aside (tangent discussion above) just to note that DCF analysis can be based on other measures than discounting free cash flows, only.  This is something I learned from Bill Ellard, who I met on the AEO Yahoo Finance! board.  Bill didn’t suggest this specific approach (for good or ill, I came up with the idea of using owner’s earnings and the concept of Sustainable Growth and Internal Growth were pulled from an old business school text).  Nevertheless, it is interesting to note that Pfizer’s ROE and ROA have been declining over the past decade, and that the portion redeployable by the company has so eaten into the results that fostering future growth from such meager returns is questionable … sort of.

In the case of Pfizer, the company has a reasonable cash stockpile from prior years:

This indicates that 28 cents per share is in cash, versus a little less than 80 cents paid out in dividends.  This means that dividends are primarily paid out of free cash flows.  This is a positive, in that the company is not depleting accumulated cash to pay dividends (the dividend would be suspect if that were the case), but it does raise concerns for dividend sustainability in a post-Lipitor world.  The company, however, has been taking steps to diversify its product mix through mergers and acquisitions, even if internally-generated growth through its new-products pipeline has been uncertain.

And that is why my earlier purchase of Pfizer was a mistake.  Simply put, I didn’t know what I was buying when it came to the research and development pipeline.  Yes, the company is strong financially.  Yes, the company’s history is impressive.  Yes, it has sufficient size to pay a premium to purchase competitors and sustain itself while its researchers search for the next break-through.  But, at the end of the day, pharmaceutical companies are like financial institutions.  The investor is gambling on success without sufficient information on which to estimate the company’s long-term prospects.

Now, this is really interesting on a number of fronts.

Buffett has argued that he wants to have an excellent feel for where the company will be in 20 years.  For pharmaceutical firms, this is not possible.  Patent protection lasts 20 years, and, since the company must file for patent protection when first identifying a new chemical compound for testing, by the time lab research, animal testing, human clinical trials, and the FDA approval process are completed, the viable life of the resultant product is just 5 years or less.

Buffett, however, owns Pfizer.  Huh?  Warren must have a crystal ball.

Moreover, as noted in earlier postings (especially, one generated for Joe Ponzio’s FWallStreet), I argued that investing in financial firms is speculative because the investor has no means of judging the portfolio of loans and investments undertaken by financial firms (banks, investment banks, and insurance).  There simply isn’t sufficient granularity to make an informed investment decision.  This isn’t just my opinion, no less than Benjamin Graham agreed in, both, Security Analysis and the Intelligent Investor, and the consultant-authors of Valuation at McKinsey and Company have found no recent approach to overcome this problem.  Consequently, I have never invested in a financial firm.

Well, the same problem exists with pharmaceutical companies, because the investor has no means of determining the future prospects of R&D initiatives.  Think about all of the promising “blockbusters” that have failed to meet their targeted end-points during stage III trials.  Think of those that have been denied FDA approval.  And think of those which have earned blackbox warnings after FDA approval.  Terrorist attacks and natural disasters do not show up with the same frequency.  We’ve had fewer than 5 acts of terrorism over the last 20 years, average 11 hurricanes yearly (most fail to generate catastrophic claims at category 4 or 5), and there have been fewer than five earthquakes in the US over the past two decades, but the same may not be said of the hoped-for “blockbusters” than weren’t.

Now, this is appreciably different from the generics — which piggy-back on the brilliance of others (and they will soon be the beneficiaries of Pfizer’s Lipitor).  Indeed, we are all the beneficiaries of pharma’s efforts, but, as an individual investor, I’m pleased that I plunked down just $2 thousand on Pfizer (a relatively small percentage), and, as a value investor, I won’t be making this mistake in the future.  Pharma, candidly, can experiment on another’s dime.

Of course, you may argue that with R&D-intensive companies increased risk produces increased rewards.  This, however, is not an immutable law of physics.  Risk and reward are not balanced if playing blackjack at the Sands in Vegas.  The rewards are decidedly insufficient to support playing Russian Roulette (even if doing so in Hawaii) or having unprotected coitus with a partner of suspect affections.  And there is nothing about pharmaceutical R&D that guarantees a favorable balance between risk and reward for the investor.  In fact, the buying and selling of equities is, in most cases, a zero-sum-game, where one side pays too much or buys at a bargain and the other side receives a premium on the sale or sells prematurely.

Finally, I would be remiss if not noting that, after passage of healthcare reform legislation, Pharma is one of the few groups potentially benefiting from its enactment.  In fact, Pharma has benefited from the no-negotiations and anti-reimportation policies of the federal government (in the US).  Some have argued that this is a mistake, but, given the speculative and unreliable aspects of generating novel therapeutics, both make abundant good sense to me.  Opponents of both policies should be asked how many medical breakthroughs they have produced in their working careers and impolitely told to “shut up” if the number is zero.

For me, however, investing is not gambling; otherwise, my wife would never allow it.  It is about buying fractional ownership of real companies when they are selling at a discount, and selling when the buyer is prepared to pay handsomely.  With Pfizer, I violated that tenet on the front-end, and, unable to value the company today, the decision to sell is equally difficult.  If unable to value a company, the investor can be taken when buying AND selling and, given the dilutive effects of inflation during the interim, can be taken while holding a stock he hasn’t valued with reasonable accuracy.


Written by rcrawford

March 26, 2010 at 11:12 am

Posted in General

Healthcare Cost and The Oracle

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Earlier this week, Warren Buffett gave an extended interview to CNBC’s Becky Quick.  By extended, I mean three hours, with commercials.  During it, the Oracle was asked about healthcare costs, which he described as the tapeworm eating at American competitiveness.

A review of past postings on this blog, concerning the subject, will reveal that Mr. Buffett’s take on the subject and my long-standing views are nearly congruent in every respect.  This includes my view that neither party has put forward a workable solution to the problem of healthcare inflation because no proposal addresses the principle sources.

Transcript and Video of Buffett Interview:  http://www.cnbc.com/id/35643967

Written by rcrawford

March 5, 2010 at 1:02 pm

Posted in General

Casting Blame for Underwater Housing Defaults

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According blame for unsavory circumstances is just human nature.  Blame is the ointment of the psyche — it relieves, if only moderately, the discomfort we feel when things go wrong and we suffer collateral damage as victims.

Even when there is no bleed-over that effects us directly or indirectly, blame is still a common psychological need.  When a surgery goes wrong, juries may compensate victims for medical errors due to nothing more salacious or untoward than simple human error — as though doctors should reasonably pay millions for something as common as human fallibility.

My wife lost her glasses this week, and my son lost his cell phone.  Both asserted that these events were a consequence of human error, and both objected to paying heavy fines for it.

Of course, surgical errors have heavier consequences and warrant higher remuneration, and, indeed, this explains a portion of the high insurance costs paid by doctors … costs which are passed down to institutional payers (insurance) and, eventually, to patients and employers in the form of higher insurance premiums, and, ultimately, to consumers and taxpayers in the cost of goods, services, and taxes.  Human imperfection is expensive.

Yes, blame is a necessary convenience, and, when there is no one else to blame, the victim is always an available target, under the logic of “Well, he should have … (fill in the super-human choice that you would ideally have made under the same circumstances).”  But, in the crisis or pivotal moment when the choice is upon us, it is human nature to make decision errors due to nothing more complex than the lack of complexity in human decision-making.  The logic center of the brain can only hold 7 ideas at a time (on average), and that means we are prone to error, because important decisions require more robust thinking than we are wired to produce.

Blessedly, we are also prone to amnesia when it comes to our errors — quickly forgetting our imperfections, while committing to long-term memory our successes.  If we had equal and vivid recall of our failures, we would avoid any measure of complexity or risk — which means we would not have children, start businesses, get married, turn on the stove, or have left the caves that provided protection to our forebears.

Of course, there are some people and groups who are favored targets for blame.  Mothers-in-Law come immediately to mind, as do lawyers, and bankers.  In fact, anyone who is more successful, good looking, powerful, or incongruously lucky represents a ripe target, because there must be an unsavory explanation for their more favorable position compared to our own.

With mortgage defaults due to underwater loans, this issue of blame is everywhere.  Underwater loan defaults follow from homeowners walking away from houses whose values have declined significantly below the loan amount — rather than due to an inability to pay the note each month.

The problem is large, and it impacts all of us.  High home-loan defaults make bankers leery of lending, and, if lending, increases the interest charged on loans.  Defaults lower the value of homes as resales glut the market and increase supply to the benefit of buyers motivated to purchase at the lowest price.  Reduced home values make consumers more reticent to consume due to a decline in the wealth effect — we are more confident consumers when the value of our investments is high enough to make us feel secure, solvent, and wealthy.  And, of course, lower home values undermine tax receipts to government, which promotes higher taxes.

Given all this fiscal carnage, someone must be to blame, and the candidates are numerous.  Some, for example, have argued that lenders are to blame, due to their lowered lending standards, aggressive marketing efforts, and willingness to lend to borrowers who lacked the necessary income to safely buy homes (financially).  So, the bankers are to blame.

Others maintain that the system which allowed lenders to off-load loans to secondary institutions (Fanny and Freddie, as quasi-government agencies, in particular) promoted lower standards by the original lenders.  So, government is to blame.

Some contend that breaking up large pools of home loans into investment vehicles — CDOs — and, thereafter, into secondary mixtures — CDO-squareds — is the cause.  So, Wall Street is to blame.

Of course, with no one in the financial chain prepared to take responsibility or suffer the losses, those who seek to legally limit the exposure of their clients bear some responsibility, and that, of course, would mean the lawyers are to blame.

Even more nefarious (frightening because it is mysterious, obscured by complexity, and international) are the derivatives, which provide default insurance for some parties and a means of gambling for others.  So, the Third-World Order must be responsible.

And perhaps the favorite target of blame is the homeowner.  If you were so poor you couldn’t afford the water necessary to generate a potty break — much less the pot to hold it –, it doesn’t take a rocket scientist to realize you have no business buying a home … even if the banker will lend you the money and begs you to take the adjustable-rate mortgage.  So, the homeowner is to blame.

Personally, I think all of this is wrong … not because each of these favored targets are without blame, but because those entrusted to prevent it were alseep at the wheel … and I’m not talking about Mothers-in-Laws.

Homes are also real estate, and, regardless of whether they were bought as investments, their value and potential for appreciation or decline make them investments.  They possess sufficient value that we treat them as we do other investment vehicles of substantial value.  At closing, we sign contracts for the property and, unless purchased with cash, the mortgage is a contract that must be signed and witnessed.  Thereafter, we insure the purchase against foreseeable disasters — such as the overflowing toilet in my son’s bathroom a couple of years ago.  In fact, the cost of a home and the property on which it sits represents the single largest investment of capital most of us will every make, and, after the empty nest arrives and retirement arrives, the home-value realized when it is sold constitutes a substantial portion of our retirement savings.  The homeowner is, therefore, right to consider the home as something of significant value and to give it a prominent degree of importance.

The lender, on the other hand, has an interest in making certain the homeowner represents a viable business partner.  Of course, this is less of a concern if the lender plans to offload the loan, but, under normal banking conventions, the lender wants assurance that the borrower can repay the loan and is a low risk of default.  That, however, is just one lender concern, but there are others to which we will turn when next considering the interests of the insurance company.

The insurance company is primarily interested in the value of the property and the risk associated with injury to it.  If the borrower fails to pay on the policy, the insurance company suffers only the loss of revenues, because the lender is under no obligation to cover damages incurred when the account is in arrears.  So, the insurer is primarily concerned with damage and, equally important, fraud.

The threat of fraud includes paying claims when no damage occurred, but it also includes arson arbitrage, where the home is destroyed in an owner-set fire for the insurance proceeds.  The financially solvent owner has little motivation to perpetrate this crime if the amount payed on the claim equals the replacement value of the property — even if there were no threat of incarceration.  Instead, arson arbitrage is only lucrative if the property is insured for a value greatly in excess of its replacement cost.

Consequently, the insurance carrier has an interest in making certain that the home is appropriately and accurately valued, and the banker has the same motivation, as well.  As the lender, the bank has little interest in issuing a loan that exceeds the value of the property.  The higher the loan amount, the higher the interest payments — which increases the threat of default.  This is partly why jumbo loans (covering homes costing more than $400 thousand) require higher interest rates — to compensate for the increased risk of default due to the higher loan amounts.

And the homeowner/investor has an interest in identifying an accurate value for the property.  Overpay for the property, and the returns on investment when the property is sold is greatly diminished and, more importantly, the higher the amount paid in total interest during the life of the loan.  During normal times, the threat of inaccurate valuation threatens the homeowner more than the lender or insurance, because the homeowner cannot diversify this risk across a large number of customers and because this unique purchase constitutes the single largest non-diversified deployment of capital for the party in this transaction with the skimpiest pockets (financially).

In fact, lets compare the purchase of a home with other common investments undertaken by non-institutional investors (you, me, and our neighbors).  Most invest savings in mutual funds —  effectively, hiring professional money managers to allocate capital and perform the valuations for us.  The managers of mutual funds, therefore, are expected to value the stocks and bonds and real estate and precious metals that form the core of their holding-choices.

By contrast, a smaller number of us invest on our own account, and, when we do this, we take responsibility for valuing our purchases.

Now, it must said that most individual investors do a poor job of valuing, primarily because they lack the training.  During the dot.com bubble, thousands of average investors were willing to pay a price for JDS Uniphase that was 120 times the company’s reported earnings.  Clearly, they never learned to sipher — add, subtract, multiply, or, in this case, divide.

Regardless, the competent individual investor values the revenue streams of the bonds they purchase (compared to the price), and, in the case of corporate bonds, consider the default risk of the issuing company and the value of the collateral designed to secure the bond.  If purchasing stocks (equities), the competent individual investor will consider the various reported or readily available ratios, such as PE, PB, PS, P/NAV, or, delving deeper, perform the discounted cash flow analysis to identify the approximate value of the company (on a per-share basis).

With real estate, this is more difficult.  If we were to value a prospective piece of real estate in the same way we would a stock, we would have to discard cash flows from consideration (assuming the property is not revenue generating).  The same holds for price to sales and P/NAV (unless undertaking significant modifications with P/NAV).  Even if valuing it on a price to book basis, the investor needs to be more accurate in the estimation of book value of a home than when doing so with long-established companies, because inflation related to book-value assets provides no margin of safety for the home buyer — as it does for the stock investor.

This means the competent real estate investor needs to value the current price for the building materials and labor, the pricing implications of builder taxes and fees, identify a reasonable ROI for the builder, and factor in the location premium, among other considerations.  In fact, those considerations would include the degree to which the market as a whole is over- , under- , or fairly-valued, in general.  These contributors to the price of a property are not publicly reported in a convenient Securities and Exchange filing, as it is with bonds and equities, and they certainly are not audited by an independent, certified, and bonded auditing firm.  Instead, the home buyer (to say nothing of the lender and insurance firm) would be operating under a system of Caveat Emptor (“Let the Buyer Beware”) if not for home valuation inspectors.

In fact, regardless of the degree to which the system became dysfunctional prior to the real estate crash, it relied on home valuation inspection to prevent the market from becoming an extreme and speculative bubble.  If the values had not represented a disconnect to intrinsic value, lenders would not confront the need to sell properties at such a substantial loss in comparison to the original loan amounts, the CDOs and CDO-Squared’s would not have been so severely undermined.  Instead, defaults would more closely represent an even exchange between the defaulted loan value and the actual value of the property.

In short, the system relied on valuation inspectors to do more than say “the house is sound and worth the price because the same model in the same neighborhood sold for a similar price last month … that will be $350 and I’ll mail you a copy of my report.”  In fact, what home buyer hasn’t thought, “The inspector spent 90-minutes looking at the house and is charging me lawyer’s rates for briefly climbing into the attic and doing a flash-light scan of the craw space … should I change careers?”

Well, the answer is that the fee was for more than just looking at the house and blessing the price, but, instead, included specialized knowledge about the costs of construction and the economics of the housing market.  It was on their independent and expert judgment that the whole of the system relied to serve as the trip-wire alarm if prices so severely exceeded intrinsic value as to make the loans suspect, the insurance invalid, and the buyer the victim of gouging.

And this is why most states passed legislation requiring home valuation prior to purchase.

When prisoners riot, we blame the felons, the guards, the parents, and the warden.  But after prisoners riot, we hire more counselors.  This strikes me as a mistake.  We should fire the counselors and promptly hire their replacements.  Why?  The counselors should have seen it coming.

In the case of Wall Street, it may have been the case that the SEC was understaffed and insufficiently trained.  With home valuation inspectors, the training may have been insufficient and the standards egregiously lax but the prices charged determined staffing, and none of us got what we paid for.

[Note:  I’ve written this piece as a thought response to an article read on an above-average investments discussion board.    The Crawford’s have not lost their home, nor are we in jeopardy of that happening.  Contributions, however, to the Robert Wealth Enhancement Fund are always welcome, as long as they do not trigger gift taxes or IRS suspicions.  If you are a close relative and my wife or I are beneficiaries of our your estate, we would prefer to wait for your donation until after your regretable demise.  If it is true that “to whom much is given, must is espected,” we would prefer to keep expectations low.  I know my limitations, even if my bride has none.]

Written by rcrawford

March 5, 2010 at 12:26 pm

A Better Approach to Valuing Net Income?

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[Note to Readers: Since purchasing BOLT, an explosion, fire, and oil leak on/from a BP platform in the Gulf of Mexico occurred.  As of today, news reports indicate that the resultant leak threatens the coastline of the Florida Panhandle, Mississippi, and Louisiana with the volume of oil exceeding the Exxon Valdez accident.  Regrettably, news reports indicate that it will take some time to drill a relief hole and cap the leak.  Further, as of this writing, efforts to contain the spill before it reaches the coast have been hampered by turbulent waters.  I have, therefore, sold my position in BOLT this morning, taking a 1.88% loss on the stock.

I am not, however, removing this article (which uses BOLT as the example case), because the approach described in it remains relevant to readers interested in undertaking more intelligent investments.  Indeed, even this unfortunate circumstance (which includes loss of life for several working on the BP platform) represents a learning opportunity for investors.  Warren Buffett has long maintained that he sells stocks when they become, either, overvalued or the prospects for the company become fundamentally impaired.  While I remain persuaded that BOLT remains undervalued and that the downside for the stock is likely limited, the informing environment for the industry now confronts significant challenges not previously present.  Indeed, just prior to this accident, the Obama administration announced the opening of a significant portion of the East Coast to drilling – a policy change that has been temporarily rescinded as government investigates the causes and considers regulatory changes.  Even if this is an expeditious process, the potential for news images of blackened Gulf beaches may be sufficient to alter the demand environment for BOLT services.  This change in the underlying environment seems likely to represent a significant strategic shift for the industry, in my judgment.

On a seemingly related note, I took profits in BP Prudhoe Bay (BPT) today, as well.  The reasoning behind that move, however, was not based on the platform accident.  In fact, the accident is likely to increase demand for the products of drilling coming from the oil fields represented by BPT as a petroleum trust.  Instead, the stock had increased by 65% (85% after taking into account dividends accumulated during my holding timeframe), and, in my judgment, the stock had become overvalued.

At present, there are three petroleum stocks that remain in my portfolio — E, PVX, and XOM.]


That is the problem with earnings … the basis on which stocks are regularly valued.  Wall Street clearly cares about earnings, but “knowledgable” investors never use them.  NEVER!

Earnings are flawed as a measure.  They rely on items that can’t be deposited in a bank — such as “GOODWILL” and “AMORTIZATION.” Even their use of depreciation is suspect, as a measure of what should be spent in the way of capital expenditures to maintain plant, property, and equipment.  And this fails to account for actual capital expenditures that may include investments toward future growth, or Catch-Up CapEx designed to make up for delayed expenditures avoided in the past.

So, the earnest investor needs a better way to determine the value of earnings, and this posting addresses that important issue.  In fact, this approach is not one that I’ve seen mentioned in graduate business school classes — which is not to say that some other quant-geek hasn’t done it before, but, if so, I’ve never seen it.

First, earnings (or net income) represents a convenience for investors — a short cut that eliminates the need for more in depth calculations.  This short cut is the denominator in the famed Price-to-Earnings ratio, where stocks below 15 (chose a number) are deemed “cheap” and those above that number are considered “growth” stocks — because the market is evidently willing to pay a premium for that expected growth.  Earnings, however, are considered imprecise, for the reasons identified above (and other real and perceived failings).

To get beyond this litany of problems, many investors use Discounted Cash Flow analysis — the measure created by John Burr Williams.  As modified by my friend Joe Ponzio, the stock analyst considers Free Cash Flows (cash from operations minus depreciation and amortization) for some defined period of time.  Joe, sagely, uses 10 year data provided by Morningstar, and, for the purposes of this demonstration, we will do the same, using Bolt Technologies (BOLT) as our example case.

At this point, it is sufficient to note that Bolt provides services in support of oil drilling, but that is less important than what Joe does does next.  His goal is to identify the free cash flow growth rate over this time, and he does this by calculating the median growth rate during running three- and five-year periods and then calculates the median of this group of medians.

This growth rate moderates the effects of economic cycles and the variances from one year to the next, and it uses medians as a conservative measure of the intrinsic free-cash-flow growth rate for the company.  Joe then reduces this median-of-medians to provide an extra measure of conservative comfort.  Depending on the degree to which he considers the company and stock to be speculative, he may reduce this growth rate by 20 percent or 25 percent for the next three years, followed by further reductions in years four through ten.

The next step is to apply this growth rate in an effort to project free cash flows over the next decade, followed by projections of free cash flows over years 11 through 20 using a 5% growth rate.  These cash flow streams are converted to current dollars using a 15% discount rate.

Add all of these present-value contributions together, plus the net asset value of the company (its accumulated assets minus accumulated liabilities), and you have the total value of the company.  Divide the total value of the company by the number shares outstanding, and you have the per-share value of the company.  Divide this in half, and you have the price you would pay if demanding a 50 percent margin of safety.

In the case of Bolt, the company is worth $280 million (by this measure).  That equates to $35.05 per share.  And the abundantly cautious investor would expect to pay no more than $17.52 per share.  At the stock’s current price of $10.56, the company is selling at discount to intrinsic value of 69.87 percent, and, if the stock price increases to equal fair value over the next year (a big “if”), the potential gain is 331.91 percent.

Using this method, the investor may wonder what the compounded annual growth rate would be at various time-frames in the future.

With years along the x-axis and percent grain up and down the y-axis, we can expect an annualized compounded return of 49.17 percent if our expected holding period is 3 years.

But 20 percent is a very high growth rate, even if the company was able to deliver such exceptional results in the past.  What if the past is not prologue and the future is not as bright as the past?  Well, we can combine DCF with sensitivity analysis to identify the degree to which the stock is under or over valued at various free cash flow growth rates.

So, if you think Bolt will grow at just 5%, the stock is undervalued by 43 percent — being fairly valued at $18.54, with an upside increase of $7.98 and a potential gain of 75.57 percent.  In fact, you can compare the current price to identify the market’s expectations for future growth.  At a current stock price of $10.56, the market evidently expects the company will grow free cash flows at less than -15 percent per year for the next decade, followed by 5% growth for the second decade.  Clearly, the market is not impressed with Bolt, and the savvy investor would be smart to try and determine why.  Perhaps the market expects that oil will go out of fashion or that the management is incompetent and will drive the company into bankruptcy.  If interested in Bolt, that is for you to decide.  Personally, I’ve come to the conclusion that Bolt is a buy, but my goal with this posting is not to tout Bolt but to suggest a different (perhaps, new) approach to overcoming the weaknesses of DCF.

DCF, of course, uses past results to predict the future, and this is a weakness.  If the results in the past have been volatile, then using methods designed to value bonds (which have steady income streams) is a poor choice, and DCF seeks to treat stocks as an intelligent investor would treat a bond.  In the case of Bolt, the results have been fairly reliable — as reliable as a company that trends congruently with oil can be.

Warren Buffett, however, uses a different measure from Free Cash Flows to determine the cash contribution generated to the benefit of investors.  Buffett calls his measure Owner’s Earnings — Net Income minus Depreciation and Amortization plus Capital Expenditures.

Clearly, Bolt benefited from $150 oil prior to the market tanking in 2008, and the industry has not recovered along with the market last year.  Despite this, Bolt’s business in 2009 was pretty healthy — four times the owner’s earnings as the prior-era peak in 2002.

Well, we can substitute Owner’s Earnigs for Free Cash Flows and calculate Discounted Owner’s Earnings Flow (DOEF) using the same approach as Joe teaches with DCF.  In fact, we can use an assortment of other measures, such as Replication Value and Earnings Power Value from Columbia Professor Bruce Greenwald, and we can compare these to the current and past stock prices.

So, at $10.56, the stock is selling at 1.22 times its net asset value (NAV) and just above the 50 percent discount to its DCF value (the grey zone).  In fact, the grey zone is below NAV.  The green line is the DCF value, and the purple line indicates fair value by Buffett’s (normally) more  conservative Owner’s Earnings measure.  Replication value ($7.96) is close to NAV ($8.68), and Earnings Power Value (which takes into account the competitive advantages of an established company) is the most optimistic of the measures, at $43.08.

As a quick aside, stocks selling at or near NAV, Replication Value, and/or half their DCF value evidence a stock worthy of consideration.  Further due diligence into the company’s competitive posture, management, and financial strength are necessary, of course.  Poor management in a gang-busters industry represents a poor choice, as does a company overburdened by long-term debt coming due in short order.

As an additional aside, the question of when to sell is often the more difficult challenge confronting value investors.  Stocks at, over, or nearing their full DCF value warrant close consideration for selling.  As taxes increase, that threshold should increase, as the government lays greater claim to your takings when selling.  This would suggest giving greater consideration to the company’s Earning Power Value as a theshold for when to sell.   Buy and hold may be dead today, but it will rise from the dead when given mouth-to-mouth resucitation by higher capital gains tax rates in the near future.

Of course, no measure is perfect and there are problems with each.  We do know that last year’s performance tends to be a predictor of coming year (plus or minus some degree of growth or diminishing of growth — measurable by the second-order derivative for those who took and understood calculus).  Regardless, the informed investor will want a way to measure the return generated last year, if expecting that the current year will produce results worthy of investment.  And this is where my “new” approach comes in.

While earnings, free cash flows, and owner’s earnings may change significantly from one year to the next, shareholder’s equity tends to remain fairly constant — increasing or decreasing, to be sure, but to a lesser degree.  This is especially true of  long-standing companies with significant accumulated equity.  Given this, it makes sense to value shareholder’s equity differently than current contributions to owner’s wealth.  Indeed, of the two, shareholder’s equity is more akin to a bond in its stability, and this warrants segregating the two if seeking to determine the owner’s earnings return on investment.

In the case of Bolt, $8.31 of the $10.56 stock price is abundantly stable in that it represents accumulated per-share equity (ShE) — total assets minus total liabilities.  The remainder is the premium paid by the prospective shareholder, above and beyond a dollar-for-dollar purchase of the company’s equity.

The investor should reasonably expect a return on both accumulated equity and the premium, but the required return would be different, given their different levels of risk.  The equity portion, which behaves more like a bond in its volatility, should be valued accordingly, while the premium possesses all the volatility normally associated with the stock market.  So, let’s tackle the equity portion first.

Here are current and, for various prior periods, earlier corporate bond rates, taken from Yahoo! Finance.

Because I began writing this posting yesterday (February 28, 2010), I have highlighted yesterday’s corporate bond rate of 6.17 percent for the 20-year single-A bond. Out of an abundance of caution,  I have chosen the 20-year single-A because it has the highest interest rate.  If you believe the firm you are considering warrants better treatment (due to its abundant solvency or stability or both), that is fine, and you may want to use a lower and more appropriate yield.

I use this interest rate to determine the single-year rate of return expected for the equity portion of the stock’s price.

This is nothing more than multiplying the equity portion of the stock’s price ($8.31) times the 20-year single-A bond rate (6.17 percent) — producing $0.51 in expected return for the equity portion.

Next, I consider the appropriate return demanded for the premium portion of the stock’s price (in this case $2.25).  This calculation is only marginally more complicated, starting with the 30-year government bond yield (which I take as the Risk Free Cost of Capital).

Again, this is taken from yesterday and is borrowed from Yahoo! Finance (http://finance.yahoo.com/bonds/composite_bond_rates).  The rate for the 30-year US Government bond was 4.55 percent yesterday.

The premium paid portion of the stock price, however, possesses full exposure to the volatility of the stock market.  So, I add to this a premium for market volatility.  While some accord a 6 percent volatility rate with other calculations, the highest rate (based on past data) I have found is 8.6 percent, and, wanting to be conservative at every turn, I use 8.6%.

Now, some investors want to add a measure that accounts for the volatility of the stock price (Beta), and this is where that additional buffer may be added.  Personally, I do not, because I have absolutely no respect for the stock market and how it prices a stock from one day to the next.  In fact, at the risk of offending you, please know that I firmly believe (and assume) that you and the millions of investors that constitute the stock market are, collectively, idiots.  Over the past couple of years, you have valued the Dow at 14,000 and at 6,000, even though both constitute measures of the current value of publicly traded companies plus all of their future cash flow contributions to stockholder wealth.  If you (collectively) were not clueless, the Dow would not have dropped by more than 50 percent in a single year.  I’m sorry, but the market is bi-polar (exuberant one day and searching for razors with which to slice a vein the next), and, as a group, I find this sort of mercurial behavior unworthy of respect.  Nevertheless, if you want to factor the market’s schizophrenia into your assessment, simply plug in Beta, and add the two or three rates together to identify your required return.  For me,  I’ve accorded a beta of one — which means the stock’s volatility is no different than the stock market, in general.

This renders a required return of 13.15 percent.  Warren Buffett, by the way, famously tends to require a 15% rate of return for his DCF discount rate.  Buffett, however, told Bruce Greenwald (mentioned earlier) that this varies based on the risk free cost of capital, and he uses 15% as a lose rule of thumb for his calculations in recent years.

So, we take this 13.15 percent and apply it to the premium paid.

This is calculated as premium ($2.25) times the required rate of return (13.15 percent), and it renders $0.30.

Next, I calculate the portion of the stock price that is most at risk — adding the premium paid plus the required returns on equity and the required return on the premium.

That renders a cost basis of purchase of $3.06.  Now, you may want to increase this by, either, increasing the equity adjustment or increasing the premium-paid adjustment, in order to further account for any perceived risk on shareholder’s equity.  This strikes me as unnecessary because we have already used the highest yield for corporate bonds and, rather than using the 10-year bond as our Risk Free Cost of Capital, have used the 30-year US Government bond.  That, however, is your choice.

Next, I divide the cost basis of purchase into owner’s earnings to identify the effective return.

With owner’s earnings at $1.36 and the cost basis at 3.06, the yield on owner’s earnings is 44.59 percent.  For most companies, this yield is much lower (much, much lower), and that is the magic of this measure.  It allows you to identify stocks generating returns not captured by the PE ratio or DCF.

This measure alone is valuable, but you can take this a step further, by calculating the percentage of owner’s earnings translating into deployable shareholder’s equity — i.e., the year-over-year change in shareholder’s equity plus dividends paid (adjusted for the tax hit, since the company determines whether you, the stockholder, will be exposed to government’s tax bite on your earnings as part owner of the company).

That, however, is beyond the scope of this posting.  For now, you have a different measure that provides an alternative perspective.

PS.  The inquiring reader may wonder why I’ve chosen to use the premium paid in the cost basis figure rather than the actual stock price.  The reasoning goes back to disaggregating the risky/volitile portions of the stock price from the more reliable — treating shareholder’s equity as though it possesses the realiability of a higher-than-average-yielding corporate bond.  This works with most companies, but a small number have evidenced more significant down-side risk in shareholder’s equity, and, for them, the more stringent standard of using the current stock price in place of the premium would make sense.

In the case of Bolt, the results of this more-stringent approach would produce:

The Retained OE (Owner’s Earnings) Yield is that portion owner’s earnings over the past decade that translated to an increase in Shareholder’s Equity (set at the 50th percentile).  This calculation does include dividends paid (adjusted for taxes).  Dividends are included in the calculation because, like shareholder’s equity, they accrue to the benefit of the investor.  In fact, shareholder’s equity per share is typically the floor under which the stock price can be drawn, given the rarity with which stocks sell for less than ShE; otherwise, the market is effectively pricing in some degree of bankruptcy risk, and the investor should closely monitor company’s position in the sector, the debt exposure, and, of course, the Altman-Z Score.

Given my lack of respect for the market’s ability to value companies, however, there should be a tangible basis for making the shift between the two yield calculations.  While the recent market decline moderately undermined shareholder’s equity for many firms, it appears that most are (or soon will) rebound with the improving economy — indicating that, for many, recent reductions in ShE represent temporary or short-term events.  A better measure of the risk for permanent or longer-term harm to ShE value would be the company’s debt exposure and its ability to cover payment on that debt.

In Graham and Dodd’s Security Analysis, they advise such an approach to valuing corporate bonds — going so far as to set the threshold for bonds at depression levels of cash generation.  The Graham and Dodd standard, by the way, is 3 times interest earned interest earned for industrials, with lesser requirements for railroads and utilities (Chapter IX of Security Analysis).  For Bolt, with no debt, this is not a problem, but we needn’t (and shouldn’t) apply this standard to our yield calculation here because the company is not, in fact, using ShE as a debt-financing vehicle.

But this does raise the question of how high should the yield be to warrant investment or consideration of investment.  Clearly, this would vary based on interest rates and the return expectations of individual investors, but, having already factored in the required rates for both portions of the stock price, the remaining yield required by the investor should likely range between 10 percent and 15 percent if the yield is based on the premium paid and between 5 percent and 10 percent if it is based on the full stock price.  Technically, any yield greater than 0.0 percent when calculated using the full stock price renders greater returns than the market rate, but value investors should expect a greedy margin of safety on every investment.  That is certainly the lesson imparted by Graham and Dodd when it comes to bond investing, as well as investments in equities.  As they note in the early chapters, bond defaults during the two market crashes that produced the Great Depression were far more common than the reduced risk normally associated with bonds would imply.  Consequently, they use the same “margin of safety” language regardless of investment class.

Written by rcrawford

March 2, 2010 at 10:12 am