RTCrawford's Weblog

I don't make this stuff up. I'm not that smart.

A Better Approach to Valuing Net Income?

with 6 comments

[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the opening of a significant portion of the East Coast to drilling – a policy change that has been temporarily rescinded as government investigates the causes and considers regulatory changes.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

6 Responses

Subscribe to comments with RSS.

  1. Robert,

    Thank you for using Bolt as the subject of your valuation analysis. Your approach appears to have at least some validity toward stock valuations and the technique appears useful, helpful. Again, it is impossible to Thank You enough for performing the analysis with Bolt as the subject.

    In the interest of attempting to perhaps improve upon your analysis, a lofty but hopefully not unrealistic goal, from this investor’s perspective, the following is offered for your review and or inclusion:

    1) The analysis appears well overly optimistic re Bolt, at the present time. This is only one investors evaluation and should not necessarily be taken as definitive. The 10.87% Retained Owner’s Earnings Yield in your blog in particular appears well high.

    2) The FCF(free cash flow) estimates at the top of your blog(in small font) are well historical and being so distant in the past, may perhaps be wholly “contradictory” to reality/current, particularly since Bolt has recently been losing market share, missing revenue and EPS consensus estimates, etc.

    It is true Bolt has done well in the past, this investor readily acknowledges that distant success; that success was years ago and may well have been due MORE to industry/sector/oil & gas exploration growth THAN Bolt’s prowess itself as an innovative, thriving, entrepreneurial company.

    Unfortunately, Bolt has Not been innovating – apparently no new Bolt products in several years now, no Bolt R&D, no industry buzz re Bolt, etc. This lack of innovation at Bolt is dragging the company’s sales inevitably downward at present:

    Bolt Quarterly Results(Revenues,EPS), from 12/31/2007:
    (Please note Bolt’s continuous revenue declines. Declines in revenues may and usually are — an indicator of declines in market share. Sales are usually considered the best general barometer for future cash flows. No company can ultimately have any cash flow unless it maintains or preferably increases Revenues.)
    Qtr-Ended Sales EPS:
    12/31/2007 $16,700K $0.42
    3/31/2008 $15,700K $0.40
    6/30/2008 $14,900K $0.48
    9/30/2008 $11,300K $0.27
    12/31/2008 $13,600K $0.35
    3/31/2009 $13,000K $0.35
    6/30/2009 $11,100K $0.25
    9/30/2009 $7,000K $0.14
    12/31/2009 $8,700K $0.17

    Again, your ideas appear useful, even sound and Thank You. Unfortunately, some of the metrics or benchmarks the analysis relies upon appear to this investor as overly and perhaps unrealistically optimistic, particularly any reliance upon distant historical data, in the present circumstances re Bolt.

    XOP, Explorer’s ETF is up 1.7% today, Bolt is similarly up about 1.1%.



    March 6, 2010 at 12:35 am

    • Quint,

      Thank you for the complimentary comments and the opposing perspective on the stock. The compliments are always appreciated, and the alternative view forms the basis on which each of us is compelled to consider that which we might be inclined to ignore. I have, therefore, gone back and reconsidered my original investment thesis, based on your observations and offer the following for your consideration.

      First, you indicate that a reduction in revenues often indicates a decline in market share. Revenues may decline across the market during a sector or market down-turn, such as we have witnessed over the last two-plus years. This reversal of fortunes has been especially severe in the oil and gas industry, as per barrel prices dropped from $150 down to $50 and now hovers around $80. During this period, alternative energy moved into favor, due to $150 barrel oil, and lost favor as oil became more competitive — prompting supporters of alternative energy to plead for increased government support. Governments, however, are in a poor position to provide that support due to deficit spending addressing the economic recession, exacerbated by reduced tax revenues attributable to increased unemployment. This environment has reduced demand for oil exploration services, despite long-term trends favoring the industry with peak oil concerns and supply/demand constraints fostered by increased demand among the major emerging market countries — China and India, in particular –, ameliorated by new discoveries in Brazil, increased extraction efficiency with existing fields, and improved technology allowing deeper drilling off-shore (with this last item benefiting Bolt).

      Second, you reference declines in EPS over the last two years. Revenues are, of course, different from earnings per share — as different as the cuisine that sits on your plate at dinner and the deposit made afterwards in the rest room. This recognition is more than a simple nicety — a distinction without a difference –, because a great deal of digestion takes place between plate and toilet and between revenues and earnings after taxes. For example, Bolt sold its clutches, breaks, and engine subsidiary (Custom Products, Inc.) in 2008, which appears to account for the EPS spike in 2008. In 2009, the company rolled over its credit line and deployed those assets toward short-term investments and purchase of new equipment, generating an outlier result in cash used with investments. That negative result is a nullity (a paper reduction in cash flows) that has no material effect on the company’s business or ability to generate favorable results in the future, and, indeed, given the company’s strong cash position, represents available funds the company is unlikely to need. Think of it as, both, an insurance policy and deployable/investable float.

      These three items appear to account for the reduction in EPS you mention, with the change in investments accounting for nearly all of the change. Cash from operations, which was $4.7 million in 2007, peaked at $10.2 million in 2008, and decreased marginally to $9.7 in 2009 — despite the economic downturn described earlier. That downturn took net income, which was $10.6 million in 2007 and rose to $14.6 million in 2008, back to $10.5 million in 2009 (on par with 2007 results). This ability to proactively manage costs, allowed the company to sustain free cash flow growth, which rose from $3.7 million in 2007 to $8.6 million in 2008 and, despite the poor sector environment, to $9.4 million in 2009 (aided by a reduction in capital expenditures from a peak of $1.6 million in 2008 down to $0.4 million in 2009.

      You mention research and development as a concern. R&D has neither decreased nor increased over the past decade, coming in at $0.3 million. This is understandable given increases in SG&A (largely devoted to marketing efforts during the favorable environment in 2005 – 2007 — rising from an average of roughly $4.2 million between 2000 and 2004, to $5.1 million in 2005, $6 million in 2006, and increasing to $8.7 million in 2009). Using the CapEx breakdown approach of Columbia Professor Bruce Greenwald, it appears that this increase in SG&A was, indeed, devoted to increased marketing starting as early 2004 and extending through 2008, with the bulk of CapEx spent on the maintenance purchases described earlier in 2009.

      Note, as well, that current assets have risen from a sustained base hovering just above $10 million through 2004 to $54 million in 2009. While inventories increased during the boom (base of just under $5 million to a high $14.9 million in 2008), cash and equivalents have risen more prominently over the last two years, from a base of $4.6 million in 2006 to $25.7 in 2009 — up from $19.1 million in 2008. Again, recall what the sector and broader economy have done during the same time-frame. Liabilities, on the other hand, have been well managed, with a reduction in accounts payable that exceed 50% of the boom-high of $3.7 million in 2007 down to $1 million in 2009. This caused total liabilities to drop from $6.8 million in 2007 to $4.1 million in 2009. Compare that to total equity, which grew from a base of around $20 million up through 2004 to $66.5 million in 2009 (a 400% increase).

      I mention all of this not to tout Bolt as an investment, but, rather, to suggest that using Bolt as the example for a new means of valuing the stock price was not a tacit effort to praise the stock for virtues identified using one method while conveniently ignoring flaws elsewhere. In other words, Bolt is not Cinderella by the method described in the core piece (under-appreciated but needing the attention of a Fairy God Mother) while, in reality, being an evil step sister by other measures of fundamental analysis. It is certainly the case that Bolt is not a candidate for bankruptcy, given its strong cash position and an Alman-Z score in excess of 16 (which is more than 5x the bankruptcy threshold of 3.0).

      The 10.9% owner’s earnings yield is not based on opinion or conjecture. It is based on cash from operations with appropriate adjustments for depreciation and capital expenditures, on the one hand, and applying the current yields on 20-year government bonds and the highest reported corporate bond yields applied to that portion of the current stock price that is stable and the less stable premium — with shareholder’s equity per share representing the stable portion and the remainder constituting the unstable portion. If seeking a greater margin of safety, you could apply a further buffer that accounts for market volatility to the premium (something between 6% and 8.6%, which would put that figure at just over 20%). Opinion and conjecture are entirely absent because this figure does not rely on a projections of future owner’s earnings beyond the assumption that they will remain constant (neither growing nor declining) next year.

      Moreover, this 10.9% yield is in excess of the 6.17% yield on shareholder’s equity and the 13.15% yield on the premium. In other words, the 10.9% yield is the excess yield above and beyond that available in the bond market, rather than the yield realized on a break-even basis.

      As for whether the growth rates are higher than sustainable, that is a judgment call, which can be defended based on the improving demand picture. The growth estimate is based on the median 3- and 5-year rolling medians over the past decade (using medians, rather than averages, to present a more conservative basis). That growth rate, as applied to owner’s earnings, is then reduced incrementally over future years (down to a growth rate of 5% for the second decade), starting with a 20% reduction next year. The discount rate of 15% is more conservative than normally applied to discounted cash flow analysis by a third — using 15%, rather than the more common 10% … with some automated systems using 7.5%. From that estimation of intrinsic value, the target price for making a purchase demands a further 50% reduction. Each of these steps is designed to building a cascading degree of conservatism designed to inflate the required margin of safety to a point well beyond that advocated by Benjamin Graham — the father of Value Investing.

      I should note that the projections are applied to a number of different return measures — free cash flows, owner’s earnings, book value, replication value, and earnings power value. Using several measures provides a span of results against which to contrast the current price, and each provides a means by which to determine the degree to which the price represents fair value for different purposes — buying, selling, holding, etc. I used free cash flows because it is a popular tool with others. My personal view is that discounted cash flow analysis is helpful but not definitive, because it fails to take into account the conversion efficiency of free cash to shareholder’s equity. Many firms retain 50% or less of realized free cash as shareholder’s equity, investing the difference toward future growth, and this requires an assessment of whether returns on future growth exceed the cost of capital. If it does not, investments toward future growth are squandered to the detriment of the stockholder. This is not the case with Bolt, however — as measured by a comparison of earnings power value exceeding replication value in each year over the past decade and by cash return on invested capital exceeding the weighted average cost of capital in the most recent year.

      Despite this, the approach described in the piece relies on no such projections of future growth. Instead, it values the most recent results and discounts them using the required rates of return from the bond market, and then poses the question of “is there a sufficient margin of safety remaining in the excess yield (beyond the bond-rate discount) to warrant consideration of the stock?” So, ask yourself whether the yield return is attractive if it is reduced by a quarter, a third, by half, etc. This is what sensitivity analysis is all about. You can then feel an increased level of comfort in your final decision — whether you decide to purchase or, for that matter, elect to short the stock.

      At one point in my investing past, I wrote pieces designed to inform the investment community about why the market was wrong and should reassess. I did this because I lacked confidence in the market’s ability to appropriately value equities. More recently, my perspective has changed. Today, I don’t care what the stock price does from day to day or year to year. As long as the company continues to increase net asset value and I am convinced I did not over-pay when originally buying the stock, that is enough to warrant holding. Now, some may argue that the market may remain delusional for longer than the average investor can sustain solvency, but that old canard only applies to those who invest on margin or rely on their investments for household cash flows. In my case, I only invest discretionary savings and retain a year’s worth of income in cash, so the market can remain delusional for a decade or longer, and it doesn’t matter.

      Finally, as indicated in the core piece, competent investors never base decisions or analysis on earnings (EPS). Earnings are the feces of cash flows and fail to accurately describe the body and metabolism that produced them. In fact, it was this recognition that prompted compelled statement-of-cash-flows reporting by the Financial Accounting Standards Board, with FAS 91 in 1987 and the International Accounting Standards Board followed suit with IAS 7 in 1994.


      March 6, 2010 at 8:49 pm

  2. The Federal Reserve’s Discount Rate is currently about 0.75% and therefore it presently is less than 1%. You indicate, “The discount rate of 15% is more conservative than normally applied to discounted cash flow analysis.” Your 15% appears inordinately high and not conservative. Borrowing costs are presently very low. The prime borrowing rate is a mere 3.25%.

    This points out Bolt’s cash and cash equivalents, as an asset class is worth only its stated value, at present. Applying high yields, high discount rates, and other high rates of return re Bolt appears to be inappropriate in the present business environment.

    This does not invalidate your investment valuation model, but it does mean it does not apply well re Bolt.

    Bolt completed its sale of Custom Products Corp. on May 6, 2008. The following are Bolt’s quarterly results since that time, from 9/30/08. Please note the continued Revenue declines, after the sale. Please accept an apology for also showing EPS; however, institutional investors do use EPS as a quantitative measure; Bolt’s ownership by institutional investors approaches something on the order of roughly 40%.
    Qtr-Ended Sales EPS:
    9/30/2008 $11,300K $0.27
    12/31/2008 $13,600K $0.35
    3/31/2009 $13,000K $0.35
    6/30/2009 $11,100K $0.25
    9/30/2009 $7,000K $0.14
    12/31/2009 $8,700K $0.17

    Most high-tech companies will allocate at least 15% of their Revenue stream toward Research and Development costs, as a necessary cost of maintaining and creating future business, and if only to help stave off competitors while concomitantly improving current client deliverables. If Bolt Technology’s average yearly Revenues are about $10M per year, that means Bolt should be spending upward of $1.5M per year on R&D, not its miniscule $0.3M; Bolt should be spending nearly five times the amount it historically has spent. Again: Very limited R&D at Bolt Technology, zero innovation. This helps explain why Bolt has had no new products announced or launched over the last three years.

    Re the oil & gas industry, particularly as it relates to seismic offshore acquisition/exploration, Bolt’s specialty, there has been no dearth of news stories over the last three years. News continues to abound about offshore seismic exploration. Bolt is just not winning as much global business as it should be.

    In the final analysis, there appears to be a Bolt management and resource management/resource allocation problem at the company. Your methodology appears sound, if not brilliant; it does not however apply well with Bolt. The company pays no dividends to its investors. Thomson Reuters presently rates Bolt an Underperform generally and specifically rates Bolt’s Operational trends as Underperform.


    March 7, 2010 at 1:20 am

    • Quint, thank you again for challenging my thinking.

      The 15% discount rate is the discount rate used for discounted cash flow analysis. It is conservative from the perspective of the investor, who, if conservative, seeks a higher rate by which to discount estimated future free-cash streams back to present dollars. If you take the current 10-year US Government bond yield of around 4% and add 8.6% to account for market volatility (in general), you get something approaching 13%. That would eliminate consideration of 7.5% and 10% as overly generous / favorable to the company’s stock price. Add to that 13% a couple of points for the volatility of the stock, and you have the 15% discount rate.

      The Federal Reserve’s discount rate is inordinately low from a historical perspective, but that only applies to the Fed’s discount rate. The other rates trade in the open market and compete with similar instruments internationally. The Fed does not control these other rates. Consequently, use of the 20-year rate for the Shareholder’s Equity portion and, even more removed from the Fed’s influence, the 20-year Single-A rate for the premium portion of the stock price strikes me as reasonable. In fact, candidly, use of those rates is conservative for the purposes used here. The intent of the OE yield is to determine the rate of return for the coming year if expecting to hold the stock for the one-year period required to avoid higher capital gains taxes (not mentioned as a motivation in the original piece).

      Moreover, the high discount rate does not overvalue cash and equivalents … just the opposite. As mentioned, the 15% discount rate is used to discount projected earnings in the future back to present dollars. If seeking to do this without reducing the value of future earnings, you would apply the expected rate of inflation – something on the order of 2.5% to 3.5%, unless expecting higher rates of inflation (some do).

      Again, the OE yield is not applied (i.e., based on estimations of future performance over 20 years or more). It simply disaggregates the current stock price into its two components, applies the two bond rates to reduce the resultant yield, and then applies the actual OE earned in the past year to determine the excess yield realized last year. There is no estimation of future earnings involved, beyond the assumption that the company will earn nothing more and nothing less than it did last year. The resultant yield may then be reduced to take into account any expected change in results for the current year. Consequently, there is no premium accorded to what the company may or may not earn on its stockpiled cash and equivalents.

      As for the results since 2008, here is one report (http://www.wikinvest.com/industry/Oil_&_Gas_Drilling_&_Exploration) supporting my earlier contention that Bolt’s claim of a temporary decline in support services struck in 2009.

      “American drilling drops in 2009 due to weak demand and lower prices while Russian drilling increases
      Since the summer of 2008, the number of oil and gas rigs located in the U.S. has fallen 50% in response to American natural gas prices and Global oil prices, which have fallen to two-thirds of their summer 2008 levels.[15] For many oil and gas producers, drilling has become unprofitable. During March 2009, oil prices fell below their levels in 2005 while production costs were close to double what they were in 2005.[16] As a result, low oil and gas prices have the potential to force oil and gas companies to cut production in order to reduce costs. Domestic oil production in the Gulf o f Mexico is expected to increase, but many oil and gas companies have cut back on oil and gas production as well as capital investments in 2009.[17]

      However, significant production cuts are capable of causing a supply glut if energy consumption levels were to return to their first-half-of-2008 levels.[18] If oil and gas producers cannot respond quick enough to rising energy demand, prices have the potential to increase substantially.[19]
      According to a report by Barclays Capital, 32% of surveyed oil production companies plan to increase spending by at least 20% in 2010.[20] According to the report, annual spending globally has the potential of dropping 15% this year compared to 2008. In December 2008, Barclays predicted spending had the potential of dropping 12% in 2009.[21] According to Barclays, spending drops are most severe in Russia, the U.S., and Canada. In the U.S. and Canada, spending has the potential of dropping 38% and 36%, respectively.[22] Spending in 2009 and 2010 depends heavily on the price and demand for oil in the second half of 2009.[23]

      In the second quarter of 2009, drilling increased internationally in response to rising crude prices.[24] Oil prices during the second quarter rose to more than $60 per barrel.[25] In response, international drilling operations increased for Halliburton Company (HAL), Weatherford International (WFT), and Schlumberger N.V. (SLB). In particular, Halliburton Company (HAL) reported revenue increases of 27% in Russia and double-digit growth in Mexico, Norway, and China.[26]


      • ↑ NYT: As Oil and Gas Prices Plunge, Drilling Frenzy Ends, March 2009
      • ↑ NYT: As Oil and Gas Prices Plunge, Drilling Frenzy Ends, March 2009
      • ↑ NYT: As Oil and Gas Prices Plunge, Drilling Frenzy Ends, March 2009
      • ↑ NYT: As Oil and Gas Prices Plunge, Drilling Frenzy Ends, March 2009
      • ↑ NYT: As Oil and Gas Prices Plunge, Drilling Frenzy Ends, March 2009
      • ↑ Blogs at WSJ: Oil Drilling Outlays May See Modest Uptick In 2010 After Big ‘09 Drop-Survey, June 2009
      • ↑ Blogs at WSJ: Oil Drilling Outlays May See Modest Uptick In 2010 After Big ‘09 Drop-Survey, June 2009
      • ↑ Blogs at WSJ: Oil Drilling Outlays May See Modest Uptick In 2010 After Big ‘09 Drop-Survey, June 2009
      • ↑ Blogs at WSJ: Oil Drilling Outlays May See Modest Uptick In 2010 After Big ‘09 Drop-Survey, June 2009
      • ↑ WSJ: Halliburton’s Global Net Boosts Hope of Rebound, July 2009
      • ↑ WSJ: Halliburton’s Global Net Boosts Hope of Rebound, July 2009
      • ↑ WSJ: Halliburton’s Global Net Boosts Hope of Rebound, July 2009”

      [End of quoted reference.]

      As for the issue concerning earnings as a Wall Street measure. None of the analysts and VPs I know on Wall Street use it, and the reasons are as indicated earlier. Use them if you want, but understand the limitations of doing so.

      Earnings are a less reliable basis on which to determine the portion of cash flows benefiting the investor, because it includes a number of non-cash items, such as depreciation and amortization. In his 1986 letter to shareholders, Warren Buffett expressed dissatisfaction with cash flows as a measure, and, if dissatisfied with cash flows, he is, certainly, dissatisfied with reported earnings. http://www.berkshirehathaway.com/letters/1986.html

      Additionally, allow me to direct your attention to the addendum at the end of his 1983 letter to shareholders, in which he goes into more detail concerning the detrimental effects of amortizing Goodwill on the analyst’s ability to accord a reasonable value for a company. http://www.berkshirehathaway.com/letters/1983.html

      While both provide somewhat technical treatments of the accounting involved, Buffett’s writing is uncommonly clear on such matters – especially, those of this complexity.

      In it (1983 letter), he notes that there are two types of Goodwill. The first is the excess paid to purchase a company over its listed tangible assets (total assets minus liabilities or net asset value), on the one hand, and the goodwill associated with happy customers, the company’s reputation, and the firm’s competitive advantages (production efficiencies, the effect of patents and trademarks, etc.). To the first form of Goodwill he ascribes the name “Accounting Goodwill,” and to the second “Economic Goodwill.”

      The first (Accounting Goodwill) is an accounting nicety that has little or no impact on the value of a company. Amortizing goodwill may alter the company’s tax exposure marginally, but it does not have an effect on EBIT, or, more importantly, the ability of the company to reinvest pre-tax earnings toward future growth or maintenance of operations. In fact, the practice of amortizing goodwill is plagued by inaccuracies in valuing assets and skewed by the price a buyer is willing to pay. (In the example Buffett provides, this skewing has the effect of doubling the imprecision on at least one major line item leading, eventually, to declared earnings.)

      More specifically, the assets may be carried at the price paid many years earlier when first purchased – something that is especially true of plant, property, and equipment –, while the buyer’s willingness to overpay when purchasing a business is legion in its volume and frequency.

      Economic goodwill, on the other hand, is difficult to assess with precision, but it is not a concern for the savvy buyer when assessing the financials, because it does not appear on the balance sheet. [Economic goodwill is an important consideration at other points in the assessment process, as he notes in the 1983 letter.]

      Finally, it should be noted that Buffett’s name is often mentioned with reverence, and his every utterance is frequently accorded the status of Holy Writ. Simply referencing Mr. Buffett is deemed sufficient to settle the issue under dispute. The value in reading Buffett (for me), however, is not in the humor laced throughout his writing or its quotability but, rather, the logic of his thinking, and this is what influences the professional analysts on Wall Street. Why? Because most matriculated through top business schools and learned the concepts of value investing during their coursework (even if electing to subsequently comport with the street standard of building complex models that serve as the basis of their valuation efforts).

      Those models eliminate from consideration accounting goodwill (whether the analyst follows the value investing paradigm or not), and this is why I assert that the trained professionals on Wall Street “NEVER” use earnings as the basis for identifying a dollar value for a stock. They may subsequently convert their assessment to an earnings basis for the purposes of explaining their views to the untrained public (during interviews on CNBC or elsewhere) but they do not use it when conducting their analysis.

      Each analyst is graded (on Yahoo! Finance and elsewhere) based on the accuracy of their projections, and their incomes rely on that accuracy. Consequently, no competent professional-analyst would risk a promising career on such a short-cut, possessing as it does all the inherent flaws described by Mr. Buffett in the two referenced letters.

      Thanks, again.



      March 7, 2010 at 9:24 pm

  3. Hi Robert,

    Glad to see you have returned to blogging. First came across your site after reading your analysis of financial companies on F Wall Street.

    I read everything in the post above but seems like I have to read it a few more times to grasp your idea properly.

    I’m long on BOLT by the way and I see many of the same things you have already suggested in both the post and comments.

    Jae Jun

    March 7, 2010 at 3:58 am

    • Jae Jun, thank you for stopping by. As mentioned in the past, Joe Ponzio and F Wall Street (www.fwallstreet.com) is, in my view, the best and most clearly-written treatment of value investing for those seeking a better understanding of the foundational concepts behind this approach — with some more advanced concepts interspersed, as well. In fact, Joe and I have stayed in touch since I created the guest piece you mention, and I’m pleased to note that his book has been well received and reviewed since its release.

      As for this piece, let me know if you identify any issues I’ve missed (to include items lacking clarity). In reading the comments from Quint, several clarity issues have become evident,and I’m indebted to him for raising them.




      March 7, 2010 at 9:34 pm

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

%d bloggers like this: