Looking beyond Net Income and Earnings per Share

Many investors worry way too much about a company’s reported net income or earnings per share, hoping quarterly earnings will beat the Street by two cents. Long-term investors should pay strict attention to a company’s overall returns on invested capital (net operating profits as a percentage of ALL the capital tied up in the company) and the incremental gains or losses that occur. A company may grow earnings by 15% and still destroy shareholder value if it must pour more and more capital into the business just to maintain this growth. This type of company is not desirable. A company that trades at three times book value while earning a return on invested capital of 8%, even in the presence of low interest rates does not possess the economic goodwill worthy of such a valuation. The euphoria of a bull market can cause these types of situations to occur and investors should be wary.

There is nothing better for investors than to buy an asset with an expanding value at an attractive price. By buying a stock at a level below its business value, you often get a double benefit: appreciation when the stock price closes the gap with business value and growth in the stock price as the business continues to expand. This gives you the opportunity for returns over and above the broad market.

A prudent investor will look at companies that have earnings with a high level of predictability that has been proven that they can can make money. Take for example the retail sector. These companies historically have as predictable a revenue stream as any sector. Take a look at S&P and Moody’s bond ratings on some of these companies – they are all AA or better (very high for corporation). This is due to their steady revenue stream that creates some predictability as to what future earnings will be.

Making long-term projections based on past performance and the ability of a company to move forward is not gambling.  Gambling is more like short-term trading of stocks with no consideration as to whether the stock is fairly valued.

How does balance sheet analysis enter into your decision whether or not to purchase a stock? If the P/E ratio of a company substantially outstrips its return on invested capital, do you take a pass on recommending the stock?

Balance sheet analysis plays a key role in our decision whether or not to purchase a stock. We focus on the rate that a company’s capital base is growing and compare this to how fast income growth is. Anyone can grow their net income, provided it continues to expand its capital base at a faster rate. Preferably, we want companies that can maintain growth without the need for additional capital.

What do you think about using discounted cash flow for intrinsic value?

The only way to realistically value any asset (stock, bond, real estate) is to estimate how much cash you can get out of it over its lifetime. This involves projecting what we think are achievable growth rates for a company and discounting them back to present value. Typically, we don’t think this works well when you are dealing with companies with unpredictable growth.  Investors should also always use caution when making forecasts well into the future.

Note: Dividends aren’t very tax efficient given that they are taxed at the individual and corporate level. Often, when a company cuts its dividend, it is a negative sign since it could indicate that a company is running low on cash.

How do you determine what a fair price is to book ratio for any specific sector? I’m guessing that stocks in the drug sector would have a different price to book ratio from companies in the financial sector or Internet stocks.

The more that a company can get out of its net assets, the higher its price to book ratio should be. This is a concept known as economic goodwill, not to be confused with accounting goodwill. At first, this may seem contradictory, but a company that can earn more with less should actually have a higher valuation. Companies that consistently earn high returns on invested capital with high probabilities of continuing this into the future are worth far more than their carrying value. This is a key concept that all investors must understand.

Companies that invest heavily in capital in order to set up a unique service seem to be the kind of company you are talking about. Are there any ways to tell when such companies will finally break out, in terms of earnings and stock growth?

At some point, companies with huge capital outlays must produce positive free cash flow in order to justify any stock price at all. We typically don’t deal with stocks that presently spend money and have no earnings to show for it. However, we have no problem with stocks that make a profit but plow back in everything they make and then some (negative free cash flow), as long as they are generating sufficient returns on capital. This type of company is still creating value for shareholders. This is why we use a return on invested capital model as opposed to a pure free cash flow model.

You seem pretty bearish on the Internet stocks with high market valuations. But, as a fundamental analyst, shouldn’t you take into consideration the potential for these companies and factor that into a risk rating? It is entirely possible for some of these companies (EBAY and Amazon) to more than justify their valuations in the long term due to the paradigmatic shift in markets.

The growth potential of these companies is factored into our risk rating. However, the fact of the matter is that buying AMZN or EBAY at their current valuations, which are astronomical to say the least, is not prudent investing. At their current market prices, the upside potential is greatly outweighed by downside risk. How much higher can companies that already have the next 20 years of earnings growth built into the stock price go? Can these companies, with their outlandish valuations and ballooned market caps, outperform the markets year after year? We don’t think so. And, if by some miraculous happening they do, is it worth the risk of holding stocks at these valuations that are yet to prove that they have business models that will bring great success over the long run? Again, we don’t think so.

Said simply, if you feel a business is overvalued you shouldn’t buy a stock at its current price.  As for the long term, companies like Google/Apple are companies that we feel can grow at a 15 to 20 percent clip annually. However, much of this growth is already accounted in their current stock prices.

What about investing in momentum stocks?

Momentum stocks can also be risky.  Would you like to be on the other side when the momentum turns down? We think investors should buy high quality companies with predictable earnings at sensible prices. This sounds easier than it is, but with solid research it can be done. Buying momentum equities is speculating and not investing; more people lose at this game than win. Markets have been extremely friendly to this type of gambling, and it is only a matter of time before this hysteria ends.  See what happened with dot-com companies in 2000’s.  We recommend you study what has occurred in history with the tulip bulb craze and many of the other irrational events of our time.

How would you go about analyzing a group of stocks or sector?

When analyzing a company, investors and analysts should evaluate every company in every sector using the same methods. Regardless of what you are trying to value, investors should always look for the best return while taking the least amount of risk.  We choose to evaluate each and every company using the same method. It is our goal to find companies whose future growth and value are relatively predicable, therefore making it that much more probable that the investment will generate solid returns.

How do you determine whether an acquisition is accretive to earnings?

When a company increases profits as a result of this acquisition it is accretive. Some acquisitions become accretive right away while others sometimes take years. Investors should not look too deep into when an acquisition becomes accretive. The most important thing is that the acquiring company paid a financially sensible price for the company it is acquiring. In many cases where an acquisition has been accretive right away, the acquiring company has still overpaid.

A lot of money is being spent on research and acquisitions in tech stocks, but companies and analysts commonly leave these costs out, saying that these expenditures will produce more income in the future. However, it seems that the future never comes, because they have to keep researching and acquiring every year. Am I missing something?

You are not missing anything! Investors must be wary of acquisitions and restructuring charges. Too often we are seeing companies set up reserves that will improve their future performance. This is why we choose to dig beneath the surface of these companies, so that we can point out some of the artificial growth and statistics that companies are reporting.

How do you determine the “rational value of the business”? Do you look at the stock price’s relationship to book value?

To us, the rational value of a business is a conservative estimate of how much cash we think can be taken out of a company over time. Some stocks should trade at or below book value while others should trade at several times book.

Our point is simple: As long as you have a long enough time horizon, you should continue to add to your position in a stock when the price falls to more attractive levels, provided the long-term fundamentals are intact.