The Investment Checklist

by Michael Shearn

  Contrast this to global asset manager Brookfield Asset Management, which is able to reinvest the majority of its excess cash flows back into its business, at ROIC of 10 to 15 percent. This allows Brookfield Asset Management to create more value.

  How to Improve ROIC

  To better understand ROIC, it is necessary for you to understand how a business can improve its ROIC. ROIC can be improved by:

  1. Using capital more efficiently, such as managing inventory better or managing receivables better, or

  2. Increasing profit margins, instead of through one-time, non-operating boosts to cash earnings.

  A supermarket chain is content earning a low net profit margin, typically 1 percent, because it turns over its inventory very quickly. It has a relatively low investment in assets because most of its assets are leased. On the other hand, a capital-intensive business such as a steel manufacturer has a heavy investment in assets. This heavy investment contributes to lower asset-turnover rates. The steel manufacturer must achieve a high net profit margin in order to offer investors a reasonable return on capital. In another example, Goodyear also has a low asset turnover rate. Although its net profit margins are comparable with Whirlpool (both a bit over 5 percent), Goodyear’s ROIC is much lower than Whirlpool’s, mainly because it has lower asset turnover. The ROIC at Whirlpool is 17 percent whereas the ROIC at Goodyear is 9.6 percent. Here are some other examples:

  A business can be more productive with its long-term fixed assets. If a business can generate more sales for each dollar of property, plant, and equipment it owns then it will be able to generate a higher ROIC. For example, a restaurant that wants to increase its ROIC might think about opening for lunch as well as dinner. This allows the restaurant to generate more sales per dollar invested in restaurant assets.

  A business can use online sales channels to improve efficiencies in inventory and sales costs, while also reaching additional markets. Williams-Sonoma (an upscale housewares and furniture retailer) began as a catalog retailer. By 2010, e-commerce represented 77 percent of direct-to-consumer revenues and was significantly more profitable than either retail stores or catalog sales. Relative to the retail and catalog business, the e-commerce site for Williams-Sonoma has a lower fixed-asset base, higher inventory turns, and a higher operating income margin which causes it to earn a higher ROIC.13

  A business can improve its ROIC through higher inventory turns (cost of goods sold/average inventory) because operating with higher inventory turns requires less capital to finance the business. The more inventory turns, the faster a business gets back the money it has spent on inventory. In effect, a business has its money invested in inventory for a shorter period of time.

  A business can collect its accounts receivable from customers faster. For example, wine distributor Constellation Brands reported, “Last year, we really focused on receivables in the United States. We were actually able to bring the number of days that sales are outstanding (DSO) down by four days. That’s worth about $9 million a day. We think that’s a permanent improvement.”14 By collecting accounts more quickly, Constellation Brands has less capital invested overall, increasing its ROIC.

  A retailer can be more selective in the product lines it carries, focusing on those that sell quickly and removing those that sell slowly. Wal-Mart opened smaller stores in 2010, compared to the mid-1990s when it opened 200,000-square-foot stores. This change helped to minimize inventory levels, and reduce capital investment. Because the smaller stores were stocked with faster-selling items, rather than a wide assortment of items, the change also improved inventory turnover. This has helped Wal-Mart increase its ROIC.15

  A manufacturing firm can use lean manufacturing to cut the inventories it needs to stock, or it can make its suppliers responsible for stocking inventories.

  When ROIC Is Less Useful

  There are certain instances when calculating ROIC is less useful, such as when the investment base does not add to the earnings of a business. This is typically the case in knowledge-based businesses such as in money management, information services businesses, or other non-capital-intensive businesses.

  For example, if mutual fund manager T. Rowe Price increases the number of desks and computers at its office, this investment will not add to the returns of the business. Therefore, calculating the ROIC of a firm like T. Rowe Price is less useful than calculating the ROIC of a firm that has a higher amount of invested capital, such as Praxair, a producer and distributor of industrial gases, which builds new manufacturing plants every year to meet the demands of its steel mill, glass furnace, or chemical plant customers.

  Do Not Rely on Historical ROIC When Making Forecasts

  One common mistake investors make is they rely too much on the historical ROIC and project it indefinitely into the future without considering that returns typically decline over time or that a business is limited in the amount of capital it can redeploy in the business. There have been very few businesses that are able to maintain high ROIC over a long period of time, and those that do often have limited growth prospects. When forecasting ROIC for a business make sure you are not extrapolating past returns without understanding how those returns were earned.

  Some examples of things you need to look out for (adjustments you would need to make) before extrapolating future ROIC include the following:

  A business may have a new product that has limited competition that allows it to earn high ROIC in the early years. If competition enters the market, you may need to reduce your forecast of ROIC.

  A retailer may have saturated its growth in the best locations and is now beginning to locate new retail sites in secondary locations, which may not generate the same returns as the older locations. In this case, you would reduce your forecast of future ROIC.

  Increased regulatory requirements may force a business to reinvest capital in the business that does not earn a return, such as when the Environmental Protection Agency (EPA) introduces new regulations. In 2002, the EPA required big rig trucks to emit fewer pollutants. The trucking industry estimated that the cost to meet the EPA requirements added $3,000 to $5,000 to the cost of an engine, which typically cost $15,000.16 This will decrease the ROIC a trucking firm can earn.

  Limitations of Making Comparisons

  When you are making ROIC comparisons between businesses in the same industry, you often need to make several adjustments to make meaningful comparisons. For example, if you are comparing the ROIC of two refineries (one that is older compared to a newer one), the depreciated cost of the old refinery will generate a higher ROIC than the one with the new refinery. The newer refinery may be more efficient and operate at a lower cost, but you would have to adjust the asset value of the old refinery for inflation to make a meaningful comparison between the two firms.

  Differences in accounting methods also complicate the ability to make comparisons. If you are comparing two firms within the same industry, you have to adjust the accounting statements of both businesses to make sure their accounting methods are consistent. For example, you would want to make sure both businesses are using the same inventory-accounting method, such as first-in-first-out (FIFO) inventory methods.

  When comparing a faster-growing business to one that is not growing, you might find that the ROIC is higher for the business that is not growing. The reason is that in a faster-growing business, investments are more heavily weighted to the more recent investment projects (such as recent equipment purchases or new store openings), leading to higher book-value denominators, thus pulling down ROIC.

  Businesses that constantly reinvest in their business to build an advantage—such as maintaining their property, plant, and equipment or investing in product development and marketing—will show lower ROIC than those that do not. This can have the unfortunate effect of producing lower ROIC in cases where managers are making prudent investment decisions and higher ROIC where managers have minimized crucial investments just to make short-term earnings look good.

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sp; Key Points to Keep in Mind

  Assess the Business’s Fundamentals

  Managers should understand and have a laser focus on what is creating value at the business. Watch out for managers with continually changing vision statements or managers who chase too many ideas.

  If a fundamental is deteriorating, then the value of the business will as well. If a fundamental is steady or improving, you can have more confidence in the business’s underlying value.

  Understand the Company’s Operating Metrics

  Operating metrics will help you gauge the true performance of the underlying business. By monitoring them, they will alert you to potential problems at the business.

  Identify the Key Risks Facing the Business

  When evaluating risks it helps to think like an insurance underwriter. Think in terms of frequency (i.e., how often in the past has the risk happened?) and severity (i.e., what is the financial cost?)

  With limited or no data about a major potential risk, consider rejecting the investment.

  Understand How Inflation Affects the Business You’re Evaluating

  Most investors think about inflation as simply prices increasing. That is not accurate. Inflation is the value of money decreasing.

  To avoid inflation’s value-destroying effects, cash flows must increase at the same rate as inflation. To do this, a business must be able to pass on price increases to its customers, be able to reduce its costs, have low capital-expenditure requirements, or have long-term debt maturities.

  Most stocks are negatively affected by rising interest rates. In a rising interest-rate environment, the price-to-earnings ratios of stocks typically drop.

  Pay Attention to a Business’s Debt

  Businesses with limited amounts of debt, or those that can pay back total debt obligations in less than three years out of existing cash flows, make safer investments.

  A strong balance sheet provides management with the financial flexibility it needs to take advantage of opportunities regardless of economic conditions.

  A business that finances its balance sheet conservatively uses long-term, fixed-rate, investment-grade, and non-recourse debt.

  The amount of total debt a business can put on its balance sheet depends on the amount and distribution of the cash flows a business generates as well as the value of the assets securing the debt. The more stable the cash flows are for a business, the more debt it can take on.

  Evaluate a Business’s Return on Invested Capital (ROIC)

  Ultimately the value of a business is based on the returns a business is able to achieve on its invested capital.

  A business with an ROIC greater than 10 percent is considered a high-quality business, whereas one with less than 5 percent ROIC is a low-quality business. The reason for this is that the higher the ROIC, the more a business is able to earn.

  What creates the most value is the ability of a business to reinvest its excess earnings in the business at a high ROIC.

  ROIC can be improved by utilizing capital more efficiently (such as managing inventory and receivables more efficiently) or by increasing profit margins.

  ROIC is less useful when the investment base does not add to the earnings of a business.

  There have been very few businesses that are able to maintain high ROIC over a long period of time, and those that do often have limited growth prospects.

  1. Standard & Poor’s Capital IQ.

  2. Wiggins, Jenny. “When Coffee Goes Cold Part 1.” Financial Times, December 13, 2008; Damian Whitworth (Interview with Howard Schultz), “I Worry About Everybody. I’m Paranoid. You Have to Be.” Times (London), March 12, 2011.

  3. Standard & Poor’s Capital IQ; Ignatius, Adi. “We Had to Own the Mistakes.” Harvard Business Review, July–August 2010.

  4. Standard & Poor’s industry reports; Moody’s ratings and financial databases, as of July 1, 2006.

  5. Moorman, James. “Telecommunications: Wireless.” S&P Industry Surveys, January 20, 2011.

  6. “Domino’s Pizza Completes Its Recapitalization Plan and Declares $13.50 per Share Special Dividend.” PR Newswire, April 17, 2007.

  7. Brookfield Asset Management website.

  8. Moody’s ratings and financial databases, as of July 1, 2006.

  9. Flatt, Bruce. Brookfield Asset Management Conference Call, November 7, 2008.

  10. Pruitt, A.D. “Cannery Loan is in Default—Vornado Stopped Making Payments on $18 Million Mortgage on the Landmark.” Wall Street Journal, May 12, 2010; Kris Hudson and A.D. Pruitt. “‘Jingle Mail’: Developers Are Giving Up On Properties.” Wall Street Journal, August 25, 2010.

  11. Standard & Poor’s Capital IQ.

  12. Ibid.

  13. Goldman Sachs dotCommerce Day Investor Presentation by Williams-Sonoma, June 22, 2010.

  14. Constellation Brands at Barclays Capital Back-To-School Conference, CQ FD Disclosure, September 10, 2009.

  15. Drug Store News, Yearbook Issue, April 1, 2010, pp. 26–29.

  16. Ball, Jeffrey. “Truck Firms Go on Buying Binge to Circumvent a New EPA Rule.” Wall Street Journal, May 28, 2002.

  CHAPTER 6

  Evaluating the Distribution of Earnings (Cash Flows)

  The future is inherently unknowable. No one can say with certainty that a business will generate a given amount of earnings two or three years from now, but we can estimate with some certainty what the range of earnings might be. The range (or distribution) of future earnings of a particular business is a key factor in how much investors should be willing to pay to invest in that business. The wider the distribution of future earnings is for a business, the more difficult it is to value that business and therefore to know at what price the business represents an attractive investment. Businesses with recurring revenue streams or those selling consumer staples have a much narrower distribution of future earnings.

  For example, at Procter & Gamble, the range of outcomes for the future earnings is very narrow: You will not see a 50 percent drop in the use of Tide detergent in one quarter. When the distribution of earnings is narrow, you can use single-point-estimate valuation methods, such as earnings yield, free cash-flow yield, and price-to-earnings ratios. In contrast, if the distribution of earnings is wide, as in a cyclical business, you need to use other valuation methods, such as scenario analysis.

  This chapter explores various factors that will help you determine whether the distribution of future earnings and cash flows is most likely to be wide or narrow. To start, you must first understand whether the earnings that were calculated under Generally Accepted Accounting Principles (GAAP) represent the true earnings of a business. To do this, you must determine if management uses liberal or conservative accounting standards. So let’s begin with that.

  27. Are the accounting standards that management uses conservative or liberal?

  Your ultimate goal in determining whether management uses liberal or conservative accounting methods is to help you determine the true operating earnings of that business. In most cases, you will need to make adjustments to the accounting numbers to understand how much a business actually earns. The reason for this is that there are many ways to calculate financial numbers under GAAP standards.

  As this book is being written, there are many changes occurring to accounting standards with the adoption of International Financial Reporting Standards (IFRS), such as disallowing the use of last-in-first-out (LIFO). Even though there are many changes occurring, the methods management can use to manipulate earnings will unfortunately remain.

  Here are several ways to determine whether management is using liberal or conservative accounting standards.

  Read the Income-Tax Footnote

  A good place to begin learning if a business’s reported earnings approximate its actual earnings is to read the income-tax footnote found in the company’s 10-K report. A business keeps two sets of books. The first one is based on GAAP accounting and the other is used to calculate the amount of taxes a business owes to the IRS. Th
e IRS books tend to be a conservative benchmark, because in most cases firms seek to minimize their tax-return income. On the other hand, management can select from various accounting methods to calculate GAAP income. If there is a large difference between earnings for these two sets of books, it will be captured in the income-tax footnote. The footnote reconciles the difference between GAAP taxes on earnings (known as the income tax provision) and the amount of tax paid to the IRS (known as current taxes).

  In the income tax footnote, compare the differences between the Income Tax Provision and Current Taxes for at least 5 to 10 years. Calculate how much book earnings are overstated or understated compared to current taxes. If you discover a business is reporting earnings yet is not paying taxes, this should set off some alarm bells, as businesses rarely cheat the IRS.

  For example, one business reported $189 million in after tax earnings, but it paid the IRS and foreign tax authorities only $5 million! That suggests a huge difference in profits reported to shareholders versus profits reported to the IRS.

  In comparison, National Presto Industries, a company that makes housewares such as pressure cookers, waffle makers, and frying pans, reported that its current taxes (both federal and state) totaled $70.9 million from 2007 to 2009 compared to a total tax provision (i.e., book taxes) of $74.8 million over this same time period. This means that its GAAP earnings approximate actual cash earnings, indicating that you would not need to make adjustments to the financial statements in order to understand what the real earnings of the business are.

  Compare Cash Flow from Operations to Net Income

  Management has less flexibility in manipulating cash flow from operations than it does net income because net income contains a large number of highly subjective estimates.