Category Archives: Accounting

100 to 1; Sales; Hedge Fund Pop Quiz

From Best to Worst.  There are typically two ways to make 100 to 1 on your money.   1. The preferred way–in my view because the company has more control of its destiny–would be to invest early in a high ROIC company that can redeploy capital at high rates for MANY years.

Note how the chart has gone sideways for 18 years as the ability to redeploy at high rates has declined. WMT can’t grow with regional economies of scale in Germany as it could in Arkansas back in 1965. You have to hold on through the inevitable 50% price plunges which you are able to do because of your understanding of the company’s competitive edge in the market.

2. Or, you find an extremely cheap, beaten-up cyclical company (TECK) in an industry that has had low capital investment, then hold on for the boom which you then sell out at the top–harder and more nerve-wracking than the example above.

The worst performing sectors are where you want to look, but realize that some industries like phone companies may be under structural change.

The Anthesis of Out-of-Favor

The Psychology of Sales

Hedge Fund Pop Quiz (Accounting)

Why is EBITDA so different than operating cash flow?  Is that a problem or an opportunity.  See: WTTR Mar 31 2018

A good research report on WTTR: Permian WDDC

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Is Book Value as Relevant as it used to be? (Part 1)

What Worked in Investing-Tweedy Browne

WhatHasWorkedFundOct14Web

Low price to book value or high book value to price was an INDICATOR of value but no guarantee to coincide with intrinsic value as Buffett explains:

“In past reports I have noted that book value at most companies differs widely from intrinsic business value – the number that really counts for owners.” Berkshire 1986 Letter

“Book value’s virtue as a score-keeping measure is that it is easy to calculate and doesn’t involve the subjective (but important) judgments employed in calculation of intrinsic business value.

It is important to understand, however, that the two terms – book value and intrinsic business value – have very different meanings. Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.

An analogy will suggest the difference. Assume you spend identical amounts putting each of two children through college. The book value (measured by financial input) of each child’s education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously – from zero to many times the cost of the education. So, also, do businesses having equal financial input end up with wide variations in value.” Berkshire 1983 Letter

“Some investors weight book value heavily in their stock-buying decisions (as I, in my early years, did myself). And some economists and academicians believe replacement values are of considerable importance in calculating an appropriate price level for the stock market as a whole.

Those of both persuasions would have received an education at the auction we held in early 1986 to dispose of our textile machinery. The equipment sold (including some disposed of in the few months prior to the auction) took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost us about $13 million, including $2 million spent in 1980-84, and had a current book value of $866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps $30-$50 million.
Gross proceeds from our sale of this equipment came to $163,122. Allowing for necessary pre- and post-sale costs, our net was less than zero. Relatively modern looms that we bought for $5,000 apiece in 1981 found no takers at $50. We finally sold them for scrap at $26 each, a sum less than removal costs.
Ponder this: the economic goodwill attributable to two paper routes in Buffalo – or a single See’s candy store – considerably exceeds the proceeds we received from this massive collection of tangible assets that not too many years ago, under different competitive conditions, was able to employ over 1,000 people.” Berkshire 1985 Letter

“Of course, it’s per-share intrinsic value, not book value, that counts. Book value is an accounting term that measures the capital, including retained earnings, that has been put into a business. Intrinsic value is a present-value estimate of the cash that can be taken out of a business during its remaining life. At most companies, the two values are unrelated.” Berkshire 1993 Letter

“We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all- important and is the only logical way to evaluate the relative attractiveness of investments and businesses.

To see how historical input (book value) and future output (intrinsic value) can diverge, let’s look at another form of investment, a college education. Think of the education’s cost as its “book value.” If it is to be accurate, the cost should include the earnings that were foregone by the student because he chose college rather than a job.

For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education.

Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn’t get his money’s worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.” Berkshire 1994 Letter

Is Accounting as Useful as an Indicator as it Used to be?

Recent years has seen the brisk rise in market value of businesses defined by their network effects and operational leverage to the new economy rather than those dependent on traditional accounting defined forms of capital. Also, we have seen rising domestic Gini coefficients despite global improvements in aggregate output. Capitalism without Capital investigates the increased investment in intangible assets and their place in the modern economy.

The book is about the change in the type of investment observed in more or less all developed countries over the past forty years.  The authors argue:

  1. There has been a long-term shift from tangible to intangible investment.
  2. Much of that shirt does not appear in company balance sheets and national accounts because accountants and statisticians tend not to count intangible spending as an investment, but rather as day-to-day expenses.
  3. The tangible, knowledge-based assets that intangible investment builds have different properties relative to tangible assets: they are more likely to be scalable and have sunk costs; and their benefits are likely to spill over and exhibit synergies with other intangibles.

Is Book Value Irrelevant?

http://thereformedbroker.com/2018/04/30/is-book-value-irrelevant/

To be continued………..

A Reader’s Question on DCF


 

 

 

QUESTION:  So the intrinsic value of a company is the present value of all future cash flows?

Now everyone has a different required rate of return or discount rate, so does that mean one person’s intrinsic value of a business will be different from another person (not because of different estimates of future cash flows but because of discount rate)?

CSInvesting: Yes, a pension fund may be fine with a discount rate of 8.5% but you require 15%.

I just want to confirm what it means when in articles, famous investors talk about their investments and they would say for example that they found a business which they think is worth $50 but was trading at $15. Is their estimate of $50 the value they came up with after using their own discount rate, or is it more a comparable analysis of using a discount rate of the industry norm and that’s the value that they come up with.

I don’t know what discount rate they are using, but when you see a company trading at $15 and you think it is worth, then probably your valuation is off.   Markets are not ALWAYS inefficient, but they are usually not GROSSLY inefficient.  Say, you value a miner based on today’s gold price of $1,200 and it trades at triple the price in two years but the gold price trades at $1,600 (US) then a speculative element changed your valuation.

 

I ask because some say they will buy only if there is a 50% discount to their intrinsic value and would sell around 90-100% of their intrinsic value.  But say for example that you used a discount rate of 20% to get your intrinsic value and it so happens to be selling at 50% discount and you bought it.  Even if price reached 100% of such intrinsic value, basically what that means is going forward for that price, you will be getting 20% returns for holding that investment, which to me is an excellent investment and would hold on and not sell (assuming that the cashflow is certain for the example).

 

I think you are double counting.   You use 20% discount rate when usually the cost of equity capital is 7% to 11% AND it trades at a 50% discount, then your valuation is probably in fantasy land.

Some go to Prof. Damodaran’s Industry Cost of Capital Spreadsheet

 

http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/wacc.htm  But I wouldn’t use it other than to see what most analysts use.
REMEMBER the iron law of CSInvesting.  If you know or do something that everyone else does in the market, then it is probably useless.

DANGER with USING DCFs

STANDARD THINKING

Better:

Chapter 8 Cost-of-Equity-Capital Credit Model by Hackel 

The analysis of risk represents the single most underexplored factor in security research and the primary reason for investor disappointment in their investment returns.

The cost of equity capital, while known as a measure of investors’ attitudes toward risk, more aptly should represent the uncertainty to the cash flows investors can expect to receive from their investment in the security being considered.  Only through n accurate and reliable cost of equity capital can fair value be established as well as the determination of whether management is creating value for shareholders, as measured by the return on invested capital (ROIC) in comparison with its cost.

Because security analysts are not confronted with the daily barrage of problems and hazards that managers and executives working directly for the entity face a wide swath of hidden risks that tends to be ignored or not calibrated properly. Investors need to think and behave like corporate insiders to truly appreciate this multitude of exposures so as to accurately place a cost of capital that takes into account these uncertainties, of which any one could damper cash flows or even threaten the entity’s survival.  On the other hand, if investors were to overweigh such risks, the entity’s valuation multiple would depress, causing misevaluation.

Say the standard tech company has a cost of capital of 9%.  Well, Apple’s might have a lower, 7.6% cost of equity capital, because of the lower operational risk of its business as noted by the cost of its credit.

Use a credit model for the cost of equity capital –See ch. 8: Security Valuation and Risk Analysis by Kenneth Hackel. (in Value Vault)

At least you are garnering a different perspective.    Good questions.

Hedge Fund Analyst Quiz

You just joined as a new analyst and your boss slaps this on your desk Adobe 2000 10K.   What is the real net income to shareholders? Assume a 35% tax bracket.

You remember from reading in Berkshire Hathaway’s 1992 annual report, “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”

FAJ Stock Options and the Lying Liars Who Dont Want to Expense Them  No need to read this to answer the question.   detective

 

 

An answer will be posted next week.    The correct answer will garner a prize and adulation.

The END of Accounting?

end of accounting

The End of Accounting An article from the Wall Street Journal. Some may wish to read this book.  On the other hand, we all should know the limitations of accounting.   Accounting was designed for credit analysis while business analysts must use more conceptual, creative thought to understand the economics of the business they are analyzing. Use the proper tool in the proper way–understand context.

Accountant

I got on the wrong bus. HELP!

 

A Money Problem

1964-money-problem2

We Don’t Have a Wage Problem; We Have a Money Problem

FYI: GAAP Acccounting gatech_finlab_lifo_42216

Don’t Spare the Rod: Critique of Investment Research Reports

Time WarnerA beginning analyst sent me a research report to discuss: Ensco PLC Write-Up

Now before I start, realize that when I was beginning, my idea of a research report was to mimic Cramer.  Buy because the “chart” looks good and I gotta feelin’.  One time my hedge fund boss said his time was worth $1,000 an hour so the six minutes he took to read my incoherent report meant that I OWED HIM, $100.  Well, we all have to start somewhere.  The point of this exercise is to learn.

Buffett’s punch   idea may apply. If you only had twenty investment ideas over a lifetime–one every two to three years–would this be it? Would you put all of your money and family’s money into the idea and why?

Or, you pretend that you have a 45-second ride in the elevator to the top of the Time Warner building with Carl Icahn while selling your idea.

Bill Miller once said that money managers had the attention span of knats. You had to summarize your thesis and then give three or four supporting reasons within thirty seconds.

My critique of Ensco PLC

Instead of four paragraphs to tell me what Ensco does, perhaps you can be more succinct while putting forth what is compelling about your investment thesis.

ESV (Ensco, PLC) is an owner/operator of offshore contract drilling rigs/services that is trading at X% under tangible book value.  This is a cyclical, asset-intensive business subject to swings in natural gas and oil prices. Over a fully cycle, the company earns normal returns on capital of XX?

The price: Enterprise Value

Returns: over several prior cycles?

Capital structure and terms of debt?

Bottom line: this is a non-franchise or asset-based investment that is currently and cyclically out of favor.  OK.   But if this is an asset based business what are the assets worth?  You would need to dig into tangible book–what is there?   What is the current and expected replacement value of their assets? Liquidation value?  Is their fleet of rigs unique? Who are their competitors?  Any hidden assets or potential assets like, say, NOLs or assets outside their core business for example?

What is their cash flow and owner earnings?   I would like to see enterprise value over EBITDA-MCX over the past decade to get an idea of how the market priced ESV over a cycle.

Who is management? What skin do they have in the game? Are they good operators and capital allocators? Insider buying?  Who owns this company?  I don’t have much to go on in the above report so I jump to my handy VL: ESV_VL.  Whoa!  I see debt has jumped about 35% from 2013. How does their capital structure compare to competitors?   It seems like there isn’t much free cash flow. Capex eats up most of the company’s cash flow.

Where is the margin of safety? Book value has been growing but during an up-cycle in drilling. What happens in a prolonged down-cycle?  What are the risks?   You mention a DCF? Where did that come from? Your assumptions?

I will let others in the Deep-Value group chime in, but for a first-ever research report I give a D- which isn’t bad. At least the writer has good instincts to look at an out-of-favor company, but the core analysis of the assets needs to be provided. Also the competitive landscape.  Obviously, it is a business without a competitive advantage due to the low and cyclical nature of the returns, so how does this business compare operationally, financially and value-wise to their main competitors? Who are their customers and how are they faring?

The only way to improve is to write, practice and look at other reports. Go to www.valueinvestorsclub.com and sign up. Then look at the highest rated ideas and study those along side the 10-K of the company mentioned.

Study Other Examples of Research

Or The_Security_I_Like_Best_Buffett_1951  Warren Buffett on Geico.

https://sumzero.com/sp/bc_winner (you may have to paste into your browser) and as reference, Rockwell Automation Inc and ROK_VL from a Deep-Value member, Thomas Harris. We can critique this next if you wish.

Carl Icahn paid $500,000 for an investment bank to furnish a report on breaking up Time-Warner: lazard_twx (worth a look!) and Icahn was right about Time Warner

Analyzing Debt

Sell ABX

ABX Sombull along with Barrick Annual Report 2014 and Barrick 1 Q 2015

https://www.coursera.org/learn/learning-how-to-learn

http://en.wikipedia.org/wiki/How_to_Read_a_Book

Stay with it………writing is hard and finding great ideas even harder.

Measuring Financial Distress Chapter 4 of Quantitative Value

nq150415

 

The corpse is supposed to file the death certificate. Under this “honor system” of mortality, the corpse sometimes gives itself the benefit of the doubt. -Warren Buffett, “Shareholder Letter,” 1984

Cryin’ won’t help you; prayin’ won’t do you no good. –My Ex.

We take up from Chapter 3 and move to Measuring the Risk of Financial distress: How to Avoid the Sick Men of the Stock Market in Chapter 4 of Quantitative Value (which you have if you are in the Deep-Value group at Google Groups).   I will email Financial Shenanigans as a supplement to this chapter of uncovering distress/fraud.

Can one predict financial distress from the outside of a company BEFORE bankruptcy. Obviously, the first place to look is at the balance sheet for the quality of the assets vs. the terms and amount of the debt. Then look at the competitive nature of the company’s industry. Airlines tend to go bankrupt more than cola companies.

I think you must practice your skills as a financial analyst. When you read about a bankruptcy like Radio Shack, then download the financials for your records and look back for what signs you might have noticed.  I will have other tips below.

Several research papers and case studies mentioned in Chapter 4 below. Especially look at the WorldCom case.

JOIM

_predicting_financial_Distress Risk 2010

Forecasting Bankruptcy More Accurately

Predicting Bankruptcy for Worldcom Final

WorldCom1 Ethics Case Study

Litigation against WorldCom for Fraud

Enron CS

WorldCom_Case_Study_April_2009

WorldCom Accounting Fraud

WorldCom

Practice your skills

You can look at these research reports from Off Wall Street and then download the financials of the companies mentioned and see if you can recreate the analysis.

NEW_EXAM_7-4-11

NEW_HGG_7-5-10

NEW_WHR_5-4-10

NEW_STRA_3-15-09

NEW_PBI_1-19-09

Blood in the streets!

CRB-Index

Gold Mining a Crappy Business

Why Gold Mining is a Tough Business_Pollitt (An interesting insight into this industry)
SEE YOU NEXT WEEK as we go into Chapter 5 in Quantitative Value.

Practice Like Jonah!

Screening out Earnings Manipulators; Quality of Earnings

budget cuts

Accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require to engage in further accounting maneuvers that must be even more “heroic.” These can turn fudging into fraud. (More money, it has been noted, has been stolen with the point of a pen than at the point of a gun.)” –Warren Buffett, Shareholder Letter, 2000.

We pick up from the last lesson and read Chapter 3 in Quantitative Value: Hornswoggled! Eliminating Earnings Manipulators and Outright Frauds.

This is an important chapter for improving as an investor. Your goal might be to understand accounting up to the intermediate level so as to adjust accounting principles into economic reality. What story are the numbers telling you?

Think of this chapter as a way to build an early-warning system for companies with weak accounting.

The authors propose three ways to detect aggressive accounting that lead to poor quality of earnings:

  1. Scaled total accruals (STA), which uncovers early-stage earnings manipulations
  2. Scaled net operating assets (SNOA) which captures a management’s historical attempts at earnings manipulation.
  3. The third is the probability of manipulation, or PROBM, a tool that identifies stocks with a high probability of fraud or manipulation.

When the growth in cumulative accruals (net operating income) outstrips the growth in cumulative free cash flow, the balance sheet becomes “bloated.” Stocks with balance sheets bloated in this way find it difficult to sustain earnings growth.  When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen.

A warning sign is high accruals that show much higher income than cash flow. See pages 64 to 68 in Quantitative Value.

Though you should read this chapter carefully and for the nerds, dig into the research papers below, but I highly suggest studying Chapter 8 in Quality of Earnings, Chapter 8 (sent via email to Deep-Value at Google Groups).   A gem of a book. and Defining Earnings Quality CFA Publication

Earnings Management, Fraud Detection and Adjusting for Accruals

How a group of Cornell Students sold Enron before the collapse

http://www.valuewalk.com/2014/10/beneish-m-score-earning-manipulators/

http://www.valuewalk.com/2013/06/red-flags-fraud-detection-2/

Information in Balance Sheets for Future Stock Returns

Earnings Mgt and LR Stock Performance of Reverse LBOs

Earnings Mgt and LR Performance of IPOs 1998

Can Forensic Accounting Predict Stock Returns

Analysts do not adjust adequately for accruals 2004

After a few days of digesting this post, we will tackle Chapter 4: How to Avoid the Sick Men of the Stock Market, in Quantitative Value.

How can we avoid bad news as investors through our knowledge of financial statement analysis and human motivations (incentives)?

Sound Money

The-Age-of-Inflation-Jacques-Rueff

A Banker for All Seasons John Exeter

An American Original: Voodoo Child

Have a Great Weekend!

 

Tawes Hockey

POP Quiz: Is a Rising ROE Good?

snowmen

I intend to live forever. So far, so good–Steven Wright

We will tackle Chapter 4 in Deep Value next week and I will find out the status of the forum for advanced students this weekend. I am swamped. 

POP QUIZ

If a company is increasing its Return on Equity (“ROE”) over time, is that an attribute of a good business?   

Since you are skeptical, you whip out your ROE diagrams:

400px-DuPontModelEng.svg

simpler

roe

Even better, you are hired as the investment banker to help advise the CEO how to enhance ROE (bonuses are based on rising ROE and increasing earnings per share).

Today, the company receives 0.00000000000001% on its money market accounts, while the CEO’s company stock trades at 34 times earnings and earns its cost of capital, 10%.   Remember, you work for JP Morgan and you have student (MBA) loans to pay off.  You sharpen your pencil and……………….?

My thoughts posted this weekend after I pass out grades.

Post: Feb. 16, 2015

Damn! I am unable to flunk anyone. There was a good discussion looking at the question from many sides because I didn’t give you much detail.  The key point is: “It depends.”  Context is key.  You could have a situation like Microsoft’s where its core businesses (Office, etc.) generate so much cash without incremental investment that cash builds up and in turn drags down ROE (equity grows without a high return on the cash). Then the issue becomes what will Microsoft do with its excess cash? Squander on new ventures and acquisitions or return it to shareholders?  Microsoft over the past six years has done a little bit of both. Perhaps low ROE means the company has no debt and thus a buffer during cyclical down turns?

Maybe this company’s ROE is suppressed by last year’s investment into new stores and more time is needed before the stores earn their expected return. Perhaps, like Costco or Philip Morris, future growth will be so profitable and persistent that buying in shares means reducing shares below intrinsic value–a long shot, how many emerging Wal-Marts, Costcos or Whole Foods are there?

The popular move which I, as a JP Morgan banker, would advise the CEO to buy back his stock with his low yielding cash (about a 0%) return and lather on low cost debt to buy stock back  to earn an approximate 3% return (1 divided by 34) despite being a mundane business (10% ROE). Even at inflated prices. You shrink share count and equity to drive up EPS and ROE. The CEO collects another bonus and you can chirp about your value enhancement strategies.  But when you buy an average company at 34 times earnings, you are paying over intrinsic value (let’s assume). Earnings and ROE rise but book value drops. Long-term wealth is reduced.   Look at tech and consumer good companies today where managements are buying in their stock near all-time highs after a six year run-up.  Few bought shares in the depths of the 2008/09 crisis.  Borrow money today at 3.5% to buy-in your stock at a 5% earnings yield. Brilliant–until the next economic downturn.

This is another lesson in incentives. CEOs are incentivized to get a short-term bump in their stock prices, long-term value be damned.

GOOD JOB to all who commented.