For this case study, it will help to know how to calculate various working capital turnover metrics – Receivable Days, Inventory Days, and Payable Days. You can find that in my Fundamental Analysis Series. But, I’ll review it quickly as we go.

Here, we have two businesses. Jimmy’s Computer Builders is a computer business for which customers order a computer, pay money immediately, and then Jimmy builds the computers and sends them to the customer ten days later. Joey’s No-Money Down Computers is trying to win over customers by offering to allow customers to pay for their computers 60 days after they order them. Otherwise, Joey operates exactly the same as Jimmy’s by building computers within ten days. Both companies use the same suppliers and have received 30-day terms. That is, their suppliers expect to be paid within 30 days of delivering parts to the businesses.

Despite operating basically the same business, Jimmy has negative net working capital of $3,288 where as Joey has positive net working capital of $4,932. What does this mean? It means that Jimmy’s business “creates” $3,288 of cash simply by operating. He collects money up front, buys parts, builds the computers, sends them to the customer and then leisurely pays back his suppliers. Joey’s business, on the other hand, requires $4,932 to operate. He needs to find a way to get cash, buy parts, build the computers, then pay his suppliers all before getting any money from his customers.

What we’ve just described is each business’ cash conversion cycle (CCC). The CCC determines how much financing a Company needs to operate and grow or how well a Company may be able to finance its own growth and operations. Let’s look at these two businesses one at a time.

Jimmy’s Computer Builders (Upfront Payments)
In the case of Jimmy’s business, as the Company receives more and more customers, each customer pays up front and allows Jimmy to use their money to finance his business’ growth as he can take their payments and invest in new inventory to build and sell. Jimmy has a negative working capital business. For Jimmy, however, if business tapers off or he’s forced to liquidate, he will lose the benefit of new cash but still have suppliers to pay. As such, in a downturn, Jimmy cannot be complacent with his cash management. In a larger sense, he can’t be taking all his extra cash and dividending to his shareholders or investing in new projects unless his business is stable or consistently growing.

Joey’s No-Money Down Computers (Delayed Payments)
Joey, on the other hand, requires financing to get his business started. He needs to find money (probably through issued debt) in order to get inventories and pay suppliers while he waits for his customers to pay 60 days later. Joey has a positive working capital (think: he requires capital to do work) business. As Joey’s business grows, he will need more and more outside financing to invest to service his increasing customers. This could be difficult and limiting. On the other hand, if Joey’s business cycles down, he should theoretically be able to collect his receivables and pay his suppliers as well as the debt he incurred to run the business. There is however, more payment risk as some customers may just not pay and Joey will be left holding the bag for having spent time and money building a computer.

Cash Conversion Cycle Days
Just how much of his business can Jimmy self finance? Or, how much cash does Joey need to finance his business? This is calculated by a simple equation:

Cash Conversion Days = Inventory Days + Receivable Days – Payable Days

Basically, the time it takes to turn your inventory into sales plus the amount of time it takes to receive cash from each sale minus the days you have to pay your suppliers shows how many days worth of cash you business either makes available or consumes. Inventory days is calculated by dividing average annual inventory by cost of goods sold (inventory turns) and multiplying by 365. Receivable days is calcuated by dividing average annual receivables by sales (receivable turns) and multiplying by 365. And, finally, payable days is calculated by dividing average annual payables by cost of goods sold (payable turns) and multiplying by 365.

As to be expected by the negative working capital, Jimmy’s Computer Builders creates 20 days worth of cash. This implies that Jimmy has 20 days to freely use a customer’s payments before either getting more cash from other customers (if the business is growing) or using this cash to pay off his current liabilities (in our example his suppliers). On the other hand, as implied by Joey’s positive working capital, Joey ‘s business has a 10 day CCC which implies that he needs outside financing of 10 days worth of operating cash in order to keep his business operating smoothly.

Here, we see historical trends in return on invested capital. I chose Google and Yahoo to illustrate how investment decisions made by these two companies have lead to decidedly different outcomes for shareholders despite the fact that both businesses could categorized as very similar. Autozone is a perfect example of a mature business can maximize shareholder return through prudent capital allocation decisions. 

The Google-Yahoo Story
Google and Yahoo have decidedly different public histories. Yahoo’s IPO happened before it was truly profitable and was very much still in its growth phase. Furthermor, Yahoo quickly embarked on a course as an industry consolidator using its balance sheet to acquire new businesses in hopes of creating scale. Because the ROIC equation used relies on TTM net income versus debt and equity capital on the balance sheet at the end of a period, this measure is necessarily backward looking. Thus, for any earlier stage growth company, we’d expect to see initially low ROIC but an eventual rise as invested capital begins generating return. The problem, however, is Yahoo is unable to maintain ROIC anywhere above 10% on a sustained basis. Given that there are many attractive equity opportunities that return 10+%, it is hard to imagine why investors would want to keep their money invested at Yahoo which is continually reinvesting net income at such low return. 

Google, on the other hand, debuted as a public company after creating a solid and profitable core business. It used its IPO to raise capital for accelerating its organic growth as well as complementary add-on acquisitions. What we see is an expected fall in ROIC as Google puts significant new capital on its books in 2004 (from the IPO), but the Company immediately shows results through net income growth and a stable ROIC >15% annually. This type of return justifies continued re-investing of profits as you’d likely be hard pressed to find 15+% return on investment elsewhere. 

Let’s see how this is reflected in stock performance. 

Yahoo’s stock between 1998 and 2008 shows an initial flurry of interest in the stock due to much investor exuberance over the Company’s potential for outsized growth. This exuberance collapses as Yahoo finds itself unable to realize ROIC in excess of 5% over its first 4 years as a public company. While the Company’s efforts seem to begin returning positively between 2003 and 2005, it is short lived and a history of poor acquisitions and investments in poorly timed strategic intiatives take its toll. From 2003-2008, the stock has tread water just as you’d expect from a business with a long run ROIC below its cost of capital. Yahoo would have done better by shareholders by distributing annual income and allowing shareholders to reallocate to other investments.

Here, we see Google since IPO. Management has shown an ability to deliver 15-18% ROIC every year since receiving IPO dollars as well as with all retained earnings from the business. Google, like Yahoo, has never paid a dividend and thus shareholders have chosen to entrust management with re-investing profits. Google, however, has delivered and valuation has increased at an annualized 31% since inception. It’s interesting to note, however, that valuation has expanded faster than the business has generated return on its invested capital. Might this be a worrisome sign? In both the Yahoo and Google cases, we’ve seen that stock appreciation tends to lead and over shoot steady state ROIC, but we’ve also seen that the market generally corrects itself as expectations become more reasonable. 

Autozone: Maximizing ROIC at a mature business

We saw above that Autozone had a period of declining return on invested capital from 1997 to 2001. The Company’s management tried all it could to continue to invest in same store sales growth and all other traditional metrics of retail success and sometimes succeeded. Unfortunately, these moves generated a CAGR of 1% in net income despite a 16.5% growth in revenues. Looking back at historicals, it was clear that the business’ profitability versus scale peaked in 1998/1999 by and it just so happened that an investor named Edward Lampert was savvy enough to buy up shares in Autozone and demand that management rethink it’s strategy.

Instead of investing in new growth that never delivered excess earnings to shareholders, Lampert demanded the return of free cash flow to investors in the form of a stock buyback. From 1999 to 2008, the company has bought back over 50% of outstanding shares returning value to shareholders who participate in the buyback and improving the valuation of remaining outstanding shares.

This is quantified by ROIC as a result of a negative equity account created by the buy backs. Since the business is able to defend its earnings power without continued new investments while at the same time decreasing outstanding equity capital, ROIC actually increases substantially and so does share value.

Income statements mislead investors
Income statements are build off of generally accepted accounting principles (GAAP). Chief among these principles includes:

• Recognizing revenue only when it is realized and earned as opposed to when cash is received (accrual basis versus cash basis) 
• Matching of expenses to the recognition of revenue as opposed to work is actually done or when inventory is purchased

These principles are designed to allow greater evaluation of a company’s profitability because it actually matches how much must be spent to earn a given level of revenues. Unfortunately, this does not always give the best representation of a company’s performance. A particular drawback to accrual accounting is the fact that expenses not matched to revenue are typically accounted to on a period-by-period basis. Most operating costs fall into this category. As a result, income statements and GAAP earnings can be particularly misleading for growing companies which may be spending more higher administrative and office costs in preparation for scaling the business, but for which accrual accounting of revenues delays the impact of sales gains.

A great example of how this can mislead investors was the hoopla that surrounded Apple’s most recent earnings report. As a result of an accounting decision to capitalize iPhone revenues over the two-year contract that users sign, iPhone sales revenues are actually only reported at 1/8th the level that they are actually coming in. For a more detailed analysis, check out Bullish Cross. 

Why free cash flow as opposed to cash generated?
The use of free cash flow comes down to an argument over enterprise value versus equity value. The focus on net income, earnings, and adjusted earnings (as Andy Zaky uses in the aforementioned Bullish Cross link) by investors is an example of determining market value. This is the value investors are generally willing to pay for equity ownership in the business. Earnings, because they include interest expense and tax expense and other expenses that come with running a business, (even if not perfect on a period-by-period basis) approximate potential distributions to shareholders in the long term. 

Free cash flows, on the other hand, are capital structure neutral. They measure how much cash the company’s operations generate and minus the minimum capital that you need to employ (maintenance capital expenditures) to maintain this level cash flow. Discounted cash flows based on FCF allow you to target enterprise value. Enterprise value is the “true” value of the business in its entirety. It’s how much you would want to pay to acquire equity ownership as well as buyout any debt held by the firm (or how much more debt you could justify adding to the firm’s capital structure). 

Value and profitability are not necessarily equivalent
What about taxes, interest expenses, and other expenses that seem to be excluded even if they are necessary? What about investments in R&D or expansion capital expenditures? This is the great dilemma of modern financial valuation. Theoretically, financing expenses and non-operational taxes and a whole host of other activities with consume cash are at the discretion of ownership and management. As a result, the value of a business can be changed dramatically by new ownership and, thus even if a company is not profitable due to large non-operational expenses, it can be very “valuable” based on free cash flow performance. And, this is where financial analysis can often unlock “hidden” value in a business. 

Full disclosure: Author is long shares of AAPL at the time of writing.

To demonstrate my process for ascertaining the security of a dividend, I’ve run a quick dividend screen on the Dow using information available through the Yahoo! Finance Stock Screener. (Given that many of these companies are issuing 4th quarter press releases, I’ve done my best to update EPS and FCF. Because audited balance sheets are typically not available in the releases, Debt/Equity and Current ratio numbers are likely from last quarter.) The screen looks for stocks with dividend yields > 3%, FCF Payout Ratio % < 60%, and Current Ratio > 1.

The dividend yield criteria is obvious. We’re looking for companies which offer attractive income return. It’s anyone’s guess when the stock market will rebound, but a secure dividend will provide the necessary cushion to ease the blow of interim volatility. 

You may be wondering why I look at free cash flow payout ratio as opposed to the traditional payout ratio which uses net income. This is because dividends are ultimately paid out of cash flow not GAAP net income. In the long run, net income is a more appropriate denominator because it provides a look at the run rate cash distribution/investment choices being made by management. But, in a recession, we care about the security of the dividend regardless of earnings. In fact, an argument could be made that in an environment which presents very few viable investment opportunities, paying out cash in excess of net income (or simply hoarding it) is the most responsible decision management could make. 

Finally, we look at current ratio which is a liquidity ratio. The goal here is to identify companies which should comfortably be able to service it’s liabilities over the next year. I choose current ratio > 1 in the screen, but generally we look for current ratio ~2 to be a healthy level. An even more conservative approach would be to look for quick ratio > 1. Given the global credit crisis, you can see why this would be a concern for us. In addition to examining a target’s ability to service current liabilities, I’ve also loaded debt-to-equity ratios into the screen. A lazy investor would simply keep a very strict and very low tolerance for debt-to-equity (i.e.  <1). But, one who’s more savvy and apt to take on higher risk for return ought to continue his diligence to determine just what the debt is composed of. Maturity dates (timing risk), lenders (counter party risk), and interest rate (interest risk) are all important factors in determining “good debt” from bad. For example, a 5:1 debt to equity ratio might not be that bad for a Company which has secured long term financing and will likely be able to refinance years from now despite the fact that the market is punishing its stock due to current credit market worries. 

On a final note, you’ll notice that Verizon Communications doesn’t quite fit the criteria of my screen. In addition to wanting to submit ten stocks for your perusal, I added this because I wanted to show a Company who’s stock has held up generally well, but has a low current ratio. This doesn’t mean the Company is insolvent. In fact, it’s likely just more a nature of the Verizon business – a mature telecommunications services provider. You’ll notice that despite relatively modest shareprice depreciation, the stock provides 6% dividend and pays out nearly all of its net income. Management of a mature business ought to do this. Generally low debt-to-equity also leads me to believe that the Company is likely in the process of reducing debt load as its need to lever for growth diminishes. 

Obviously, this list is just an initial screen. There are definitely some interesting picks in there and all are trading well below their 200-day moving averages implying (if you believe in it) potential for mean reversion in addition to very attractive dividend yields. I’d be interested to hear thoughts from anyone who’s looked at these stocks in more detail as far as whether or not they feel my screening criteria were at least directionally correct. 

Full Disclosure: Long shares of GE at the time of writing. No positions in any other stock mentioned. 

Basically, we’re going to do discounted earnings analysis making the assumption that long-term earnings and cash flow should be relatively similar. Thus, we can calculate a fair value for the company based on earnings and use this to establish fair value P/E multiples.

Thus, for a no growth company we have the following equation:

from this we can quickly see that we can get a no growth P/E for any discount rate simply by dividing both sides by E to yield:

Using standard discount rates of 8, 10, and 12 percent, we get no growth P/Es of  13.5, 10, and 8.3. Here’s we find one of the main fallacies of the PEG ratio. As  P/Es can clearly exist reasonably for a company which is not growing its earnings. A no growth company trading at a P/E level below 8.3 is likely to provide significant value to its investors provided it has begun returning earnings in the form of dividends. The PEG ratio for such a company would be either non-existent or near infinite suggesting a poor value.

Now, let’s look a company which is growing its earnings. The discounted earnings would be as follows:

And, predicted P/E:

Clearly, if we were to divide this by g, we would get a target PEG ratio. Here, we hit a quandry of sorts. The g term in the PEG ratio is typically the consensus estimate for next year’s growth. The g term in our discounted earnings model is the long term growth rate for the company which cannot exceed the required rate of return as logically the long term growth rate ought to be about equal to that of the overall economy. In the US, this amounts to about 3%. As it is near impossible to project out a company’s earnings growth to the point that it’s earnings fall in line with the economy. In fact, many companies will re-invent themselves before they allow such a thing to happen.

It seems that it is here that my absolute PEG calculations hit a dead end. That being said, I think we’ve done a lot today and I may continue this series next week. What have we learned? Well, first and foremost there clearly is a mismatch between Price to Earnings and Growth from a units standpoint. It is clear from our analysis of a no growth company that fair value P/E can exist even when growth does not. The key now is to determine if there is a usable range for the PEG ratio or if maybe the only thing we can do is use it as an indicator of relative value as discussed in the previous post on the PEG ratio.

I’ll take the weekend to think of how to better analyze the PEG model we developed using discounted earnings analysis and will report back on Monday. Also, today is the last day for you all to comment in attempts to win a free book. The leader right now is “TheWildInvestor” who has commented once since the free book contest began. Suffice it to say, I’m a little sad.