An Exchange on ROIC...the Key Measure of Profitability

Over the long term, it’s hard for a stock to earn much better than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.

- Charlie Munger

(as quoted on p.233 of Seeking Wisdom: From Darwin to Munger by Peter Bevelin)

A reader and I shared a recent exchange about the quote above. I thought it was worth sharing some of the thoughts on the blog. Here you go...

Hi Derek, 

It's a Charlie Munger quote, and it's among the most important constructs for any long-term investor to understand. It goes to the heart of the return on invested capital (ROIC) portion of the economic model of a business. (See 3(d) of, "Does the economic model work?" from theMad Men MBA 4-Part Framework for Really Understanding Companies.) 

Consider this...a company has $1M of invested capital (equipment, buildings, accounts receivable, etc.) supporting its business. It earns $60K on that each year, meaning it sports a six percent ROIC. Tell yourself that $1M is cash in a savings account and the $60K is your interest on your principle. The concepts are the same. You can grow your overall interest earned (earnings) by putting more cash into that account (increasing its capital), but the rate of return remains the same...a lousy six percent.

For the company, the earnings can go one of three ways in the future: 1. They decline; 2. They stagnate; or 3. They grow. What happens to those earnings is important, but it's most important in the context of what happens to that base of invested capital at the same time. Let's consider number three, where the earnings grow. (That tends to be the happiest scenario.)

Say the earnings grow ten percent a year, going from $60K to $66K to $73K to $80K, etc. Ten percent growth seems pretty good, but we have to ask how much capital had to be invested in the business to generate that earnings growth. We must always look at earnings in the context of invested capital.

If the invested capital stayed steady at $1M, you're looking at a rosy scenario in which a business doesn't have to add to its capital base to grow. That means it can probably pay out those earnings to shareholders without fear of losing its competitive position in the market and continue to compound its value. It started off earning 6% ROIC, but that number grows with each passing year (6.6%, 7.3%, 8%, etc.). 

You won't find a lot of business like this. The vast, vast majority must plow back capital in order to increase earnings.

How much is this business worth? That's up to the judgment of individual investors, each of whom must attempt to predict the future in terms of whether this growth rate continues. (Are the earnings protected by competitive advantage? That's number two on the Mad Men MBA framework.) My threshold for an investment is a 15 percent yield. That means with earnings of $60K, I want to pay no more than $420K ($60K x about 7). But if I'm confident those earnings will continue growing at 10 percent, I might be willing to look, say, three years into the future, take that $80K in earnings and pay 7x that number (about $560K). But only if I'm confident that ten percent earnings growth (plus little additional capital reinvestment needs) continues deep into the future. 

That exercise is nothing more than an abbreviated form of discounted cash flow. Of course it's unlikely you'll find too many businesses with $1M invested in capital, earning only six percent ROIC, trading for a fraction of its capital. Someone would likely buy the whole company, liquidate it, and take the cash for a fast, hefty, and low-risk return.

But what if earnings are growing at ten percent while invested capital is growing at 15 percent? Now the economic value of the business is being destroyed with each passing year. What would you pay for a business like this? Nothing! Unless you have the power to shut it down and cash it out. As a shareholder, you'll never get the benefit of those earnings because the business has to plow all of it back into property, equipment, accounts receivable, etc. 

Munger's quote is really highlighting the famous dictum from Ben Graham's, "in the short run the market is a voting machine, but in the long run it is a weighing machine." In the short run, investors will have different opinions of the prospect for this business. The different views can lead to wildly different prices each is willing to pay, and that can lead to a lot of volatility in the stock price. 

But over the long run, the economic viability of a business (its ability to compound earnings at a rate AT LEAST equal to its need to reinvest capital) will define its price. That's the weighing machine. If it returns six percent ROIC, even if you buy it at a cheap price, you won't get much better than six percent returns over extended periods of time. If it returns 20 percent (and you think it might be able to keep that up for a while), you can buy it at almost any price and you'll do fine. 20 percent is a powerful rate for compounding any number if you give it enough years to do its compounding work! 

To get a mathematical proof, create an spreadsheet. Start with $1M on the row A. This is invested capital. To its right, multiply it by whatever ROIC you expect the company to earn. Say 1.1 (10 percent) and push that out 19 more rows compounding at the same rate each year. 

On row B, start with $60K for earnings. To its right assign whatever multiple you want for its growth, and push that out 20 years. 

On row C, divide B by A and show it as a percentage. This is your ROIC.

Now, if you select variables in which the growth of the invested capital outpaces the growth of the earnings, you'll see the ROIC creep closer and closer to zero the more years you extend the simulation. The company is eating itself. It has no economic value.

If you select variables in which the growth of earnings outpaces invested capital, you'll see those ROIC and earnings grow the further you push out the model. The business is creating economic value, and it's worth a lot more. 

But it's far less about creating a mathematical proof, and much more about understanding the concept of return on invested capital. A proof might lead you down the path of seeking false precision; searching for that perfect screen that unearths all the best ROIC companies. I think of it more as a way of looking at the world of investment opportunities while thinking in terms of compounded earnings. The more a business can grow its earnings without reinvesting them (as capital) back into itself, the better its ROIC...the more it pays out to its investors (dividends or share repurchases) while continuing to compound.

Kind regards, 

Paul

Mad Men MBA - Heinz (HNZ) Case Study in Competitive Advantage

Doug wanted to get me watching the AMC hit series Mad Men and so proposed a series of case studies on companies featured on the show. He had me at case study. Thus was born the Mad Men MBA, a collection of articles exploring the strengths and weaknesses of the businesses being pitched by the admen at fictional Sterling Cooper Draper Pryce.  We conduct our analysis based on a four-part framework, ("for really understanding companies") outlined here. In the end, we try to make this a practical exercise, estimating a reasonable price for buying the business and deciding whether it's a worthy investment today.

Our first case is H.J. Heinz, Inc. (HNZ), the undisputed champ in today's ketchup market and a key account Don Draper and crew were trying desperately to retain in season five of the show (representing the early-1960's).  In episode five, At the Codfish Ball, Jack Heinz is preparing to take his lucrative Heinz Baked Beanz marketing budget to another ad agency. Draper's young wife catches wind of the defection while powdering her nose with Mrs. Heinz at a dinner meeting, relays the tip to her husband, and sets up a dramatic ad-man pitch to keep Baked Beanz with Sterling Cooper Draper Pryce.

Today baked beans is a big business for Heinz in the UK market but has much less importance globally. The big brand is Heinz Ketchup, providing over $5 billion of its $11.6 billion in 2011 sales and with a global market share close to 60 percent. 

Doug sets up the case study in a recent email:

Heinz's big challenge was defining itself after pure domination in the baked beans market. They were friends to the military and the ease of packaging their product for wartime solidified their position. But they also had the vision to know they needed to branch out into new product territory, especially in times of peace. Ketchup became their big push and more than the product their packaging became signature. Pounding of the glass bottle to get it started and even when it pours out, it is all good. You can never use too much ketchup.

That was the 1960's, let's bring it back to the Heinz of today using our four-part framework for understanding businesses.  

Competitive Advantages: The Heinz Ketchup X-Factor

Competitive advantages serve to protect a company's earnings from attack by other businesses eager to steal their customers and their profits. The best companies are protected by advantages that intertwine around each other, creating greater protection in combination than any one of them could individually. Heinz is a clear beneficiary of the intertwining gestalt effect, distancing it from much cheaper catsup alternatives offered by Hunt's, Del Monte, and countless private labels offered by grocery stores. 

We should start out with what we can only describe as an "X"-factor that protects Heinz's ketchup empire. 

In his excellent 2004 The New Yorker article, "The Ketchup Conundrum"*, Malcolm Gladwell sits down with food-tasting specialists who describe how the human palate possesses some intrinsic attraction to flavors with a specific balance among salty, sweet, sour, bitter, and umami. If a particular food or drink strikes the right harmony - the specialists call it "high amplitude" - it keeps drawing consumers back for more. From Gladwell's article:

When something is high in amplitude, all its constituent elements converge into a single gestalt. You can't isolate the elements of an iconic, high-amplitude flavor like Coca-Cola or Pepsi. But you can with one of those private label colas that you get in the supermarket...Some of the cheaper ketchups are the same way. Ketchup aficionados say that there's a disquieting unevenness to the tomato notes in Del Monte ketchup.

Products with high amplitude resonate so much with consumers that they can eat more and more without ever seeming to grow tired of it. So businesses that somehow stumble upon the right formulation for achieving high amplitude - Coke, Pepsi, Heinz - have some sort of built-in advantage rooted deep in the physiology of the human taste buds.  

This creates such consumer demand for Heinz ketchup that they pick it over the alternatives, pay more for it, and even favor restaurants that allow them to slather their burgers and fries with this particular Heinz condiment. The high amplitude has created a strong consumer preference, giving Heinz an opportunity to combine the flavor preference with an emotional attachment by investing heavily in creating a brand. Heinz has wisely exploited this opportunity, and it's effects are undeniable. It has created a preference so powerful that we can recount multiple experiences of sitting in a restaurant and watching as a waitress picks up one of those iconic glass Heinz bottles (surely a Don Draper recommendation) to refill it with a cheaper alternative like Hunt's. Ketchup counterfeits! The restaurant would only bother to do this if they knew customers had a strong preference for Heinz. It doesn't want to pay extra for carrying the premium brand, but it sure loves the benefits of the Heinz halo effect.  

This high amplitude "X"-factor sounds like a pretty compelling competitive advantage. But it doesn't operate in a vacuum. As we explored in a previous article, Scale Advantage and the Great Coke Scandal (where a secretary at the cola company tried to sell Coke's secrets to Pepsi), the success of even the most delectable of food and drink products are not born solely of taste. It creates demand, but the companies must work tirelessly to build additional advantages to fortify this consumer preference and brand. 

Like Coke, Heinz has developed deep relationships with grocery stores and restaurants to get its ketchup on shelves and tables. That's distribution, a component of customer captivity or the network effect. If Heinz can tie up enough shelf-space with its ketchup, it doesn't leave much room for fresh alternatives to establish a toehold to compete. Heinz invests in this distribution network and guards it jealously. Any new entrant that Heinz deems viable that tries to get into the grocery stores will meet a ferocious counterattack to box it out.  It's very, very hard to break through.

Finally, there's the scale advantage that allows Heinz to practice selective low-cost, low-price tactics. While it charges a premium over other ketchups, Heinz produces such an enormous amount of ketchup that it has all sorts of scale benefits. From buying tomatoes in massive volume, to running more throughput in its manufacturing facilities, to spreading its advertising budget over a much wider base of sales...each of these reduce Heinz's cost per unit of ketchup bottle produced. If push comes to shove and a competitive product tapped into its own "X"-factor (thereby threatening Heinz's market dominance), Heinz could - by virtue of its low-cost scale advantages - undercut the emerging threat. It could push them into a price war, and Heinz's scale advantages would provide it the ability to price its products lower for extended periods of time without threatening the survival of the company.

So we see that Heinz has intertwining advantages to protect those earnings from encroachment by competitors.

Information sources:

* Malcolm Gladwell's excellent 2004 article for the New Yorker, The Ketchup Conundrum, is available on his website: www.gladwell.com/2004/2004_09_06_a_ketchup.html.

** Information about Heinz business performance and history is pulled largely from the company websites, www.heinzketchup.com and www.heinz.com/our-company/investor-relations/presentationswebcasts.aspx. We pulled from the company's strategic overview slides from a 5/24/2012 presentation available on the investor relations website.

Contemplation on Owner Earnings: Buffett's 1986 Letter

One of my college professors revered Abraham Lincoln, seeing him not only as a remarkable leader but also placing him among the pantheon of great political thinkers.  As such, this professor enjoyed sharing anecdotes and insights gleaned from the life of Lincoln. 

I recall one insight in particular. 

Aesop's Fables was one of the few books to which Lincoln had access as a child. And so he read it assiduously for years, memorizing his favorite tales and ruminating on the meaning of each. According to my professor, the stories shaped Lincoln as he carried the morals with him throughout life. But perhaps more importantly, Lincoln internalized the practice of narrow-yet-deep reading in which he allowed his mind to fumble through the many layers of nuance in what he read, struggling with the material in an effort to internalize its lessons and understand it at the deepest level.

The professor urged us to develop the same skills, assigning us the task of writing papers on the briefest excerpts from Plato, Thucydides, or Montesquieu. We were not allowed to go to other sources for hints at what the philosophers might have meant. Our job was to struggle with the original text, fumble through the possibilities, and dig deep to explain its meaning in our own words. 

This was torture! My skill - refined by much practice - was making a cursory run through the material, pulling in quotable commentary from published scholars, flowering my prose with SAT vocabulary words, and punching the essay home with a nice summary. I became quite good at writing long papers with very little actual thinking required.   

I still struggle with going deep. My attention span still prefers wide-and-narrow reading versus Lincoln's narrow-yet-deep approach. But every once in a while I'm pulled back to learn and re-learn from old pieces. So, without further ado, here's the segue...

*****

Buffett Defines Owner Earnings (1986)


If ever there were a single piece of valuation wisdom worth revisiting again and again to internalize its lessons, it just might come from Warren Buffett's 1986 Letter to Shareholders in which he outlines the case for owner earnings versus those required by GAAP reporting. Berkshire Hathaway's purchase of Scott Fetzer provides the example. (Scroll to the appendix, entitled Purchase-Price Accounting Adjustments and the "Cash Flow" Fallacy.)

Buffett writes:   

If we think through these questions, we can gain some insights about what may be called "owner earnings." These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges...less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c).

Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes - both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes's observation: "I would rather be vaguely right than precisely wrong."

...Most managers probably will acknowledge that they need to spend something more than (b) on their businesses over the longer term just to hold their ground in terms of both unit volume and competitive position. When this imperative exists - that is, when (c) exceeds (b) - GAAP earnings overstate owner earnings. Frequently this overstatement is substantial...

..."cash flow" is meaningless in such businesses as manufacturing, retailing, extractive companies, and utilities because, for them, (c) is always significant. To be sure, businesses of this kind may in a given year be able to defer capital spending. But over a five- or ten-year period, they must make the investment - or the business decays.

When one first reads this passage, one is tempted by the variables. One is eager to plug them into a simple formula, the values for which one might pull straight from an accounting statement. One hopes the quick calculation yields the secret of the true value of the business.

Owner Earnings = (A) Reported Earnings + (B) Various Non-Cash Charges - (C) Capex and Working Capital Necessary to Retain Current Competitive Position 

(A) and (B) give one much hope. But alas, (C) is confounding. It requires tremendous knowledge of the business and the economics of the industry to come up with even a reasonable guess of that value. Even managers of the company can be very wrong when trying to determine what portion of the earnings must go back into the assets or working capital just to keep the business from losing ground.

Owner earnings are those that are available to be plowed back into the business in order to create even more earnings in the future (capital investments, investment in expense infrastructure, or acquisitions) or paid-out (dividends, share buybacks, debt repayment) to shareholders.  They are the only portion of earnings that provide economic value to owners! If you owned the business outright, they are the portion you can strip from the business for different purposes while remaining confident you have left enough that it keeps laying golden eggs for you year after year. 

In his 1984 letter, Buffett calls these unrestricted earnings. In essence, the managers can use their discretion when deciding how to use this money without fear of injuring the competitive position of the business. 

By way of contrast, restricted earnings - which are the same as (C) and which Buffett calls ersatz* - cannot be pulled out of the business without causing damage. (It's like running to stand still. By continuing to reinvest the restricted earnings, the prize is standing your ground...not ceding market share to your competitors; keeping earnings at the same level as today. But if you don't reinvest, your business decays over time.) 

The trick, for managers and investors alike, is figuring out what portion of capital expense and/or increased expense structure is needed to maintain the current earnings versus how much is going toward promoting earnings growth in the future.   

*****

Amazon.com In This Context

In a previous post we noted that Amazon.com is being criticized that its torrid pace of revenue growth has not been matched by proportional earnings growth...at least not over the past few quarters. Its expenses are soaring as it leans into its growth and into shoring up its competitive position in key markets.

This is the question I want to explore...

Is Amazon increasing its spending - and thereby reducing its profits today - because

1.) It has no choice and is acting out of defense to preserve the current stream of earnings? In other words, Amazon has increased its spending in order to hold off competition and maintain market share. If it weren't investing in price reductions, subsidized shipping, content, engineering talent, etc. competitors would be stealing customers, market share, etc. 

Or...

2.) By design, it is on the offensive? It's making investments in gaining market share or otherwise strengthening its competitive position with the objective of expanding earnings in the future?

We'll consider those questions next.

*Ersatz Earnings...Restricted vs. Unrestricted (Buffett's 1984 Letter)

...allocation of capital is crucial to business and investment management. Because it is, we believe managers and owners should think hard about the circumstances under which earnings should be retained and under which they should be distributed.

The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let’s call these earnings “restricted” - cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.

Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential...

...Let’s turn to the much-more-valued unrestricted variety. These earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business.

This principle is not universally accepted. For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders - to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.

Aeropostale (ARO): Part Two - Valuation Thoughts

In the last post we looked at several assumptions that, when accepted as more-likely-than-not correct, paint a picture of Aeropostale as a business with a market that's not going away and seems to benefit from barriers that would prevent competitors from encroaching. On those fronts, it shows real promise as an investment opportunity.

Now I want to look at a few scenarios for thinking through its value. When we initiated our ownership position in late-October, ARO was trading just below $14 per share. Today it's nearer to $18, and we'll use the more current price in considering a range for its intrinsic value.

For the following, we'll use these given assumptions:

1. ARO has 4.2 million square feet of retail space across its store base,

2. It will be taxed at 40 percent of operating income,

3. It has about 82 million shares outstanding, and

4. Its current share price is $18.

Now, let's plug in some variables to see how the business looks on a price-to-value basis.

Scenario I: Ugly Forecast   

Here we assume that ARO continues taking a licking. Sales drop 20 percent from its 2010 high of $626 per square foot. Gross margins match the lowest of the previous ten years. And SG&A expense are the highest in ten years.

At the conclusion of a year with this sort of performance, the market would certainly punish ARO further. Unless this was clearly the bottom of the business challenges, the drop may be warranted. If it were the bottom, it would represent an excellent buying opportunities if we continued to believe in the assumptions from the previous post (i.e., that ARO is a strong business in a niche market with long-term protection against competition). Indeed, the scenario reflects what happened to ARO in October 2011 when it dropped to a long-time low of a little more than $9 a share.

So, if performance continues to deteriorate and key metrics revert to multi-year lows, there is easily the potential that the investment loses 50 to 60 percent of its value. That would hurt, but (again) if you believe in the assumptions, you would see this as a temporary set-back and an opportunity to jolt your returns by buying more shares.

Scenario II: Rosy Outlook   

Here we assume that ARO reverts to its best performance over the previous ten years, though I only assume a 12-15x multiple on its earnings. (It's worth highlighting the multiple is probably on the low side of what the market would do. I believe buyers would be energized and optimistic, rewarding the stock with an multiple around of 20x.)

That might be fun to think about, but I wouldn't put money behind it. Suffice it to call this the upside scenario and leave it there.

Scenario III: Going By the Averages   


Not too hot, not too cold. This is the one I put my money behind. The plug-ins are conservative based on ARO's actual average performance over the past six or so years. The multiple range remains below the S&P 500 market average, despite ARO being a business with excellent returns on invested capital and a history of compounded earnings growth in excess of 20 percent.

To build an intrinsic value calculation for the business, I would take this "averages scenario" with $191 million net income, grow earnings at a conservative five percent compounded, and pay out excess cash in the form of share repurchases. At an 11x earnings multiple, it's not difficult to see the business worth nearly $60 per share five years out for a 27 percent compounded gain on the investment.

If you have the conviction that your analysis is roughly accurate and your assumptions sufficiently conservative, $18 per share is a great place to build a position.

Hasbro (HAS): Part Two - Quick & Dirty Stab at Valuation

So I'm attracted to Hasbro because it appears relatively cheap at around 11x price-to-net earnings, has a respectable 10-year track record (per Morningstar's collection of its financial data), and has stable of toy brands that look strong, many of which I remember loving as a child.

We start off by listening to a Mattel presentation on the merits of the toy industry. It suggests good growth opportunities and stability through the roughest times. The past is no guarantee of future performance, but it's a pretty good place to start. I'm much more at ease extrapolating a long history of good performance into expectations for the future than I am looking at track record of bad results and expecting the business to change. So we invest a little more time to see where our research takes us.

In mid-2010 I created a humble model, a stress test of sorts, through which I would run prospective investment opportunities to see if they present a comfortable margin of safety. In simplified manner, it works something like this:

First, I look at the business's growth rates over the past seven to ten years, paying particular attention to owner earnings it generates (more or less operating income plus depreciation minus taxes minus interest minus my estimates for cash needed for maintenance capex and maintenance working capital growth) and what it does with those earnings  (i.e., does it let it accumulate as cash reserves? plow it back into the business? use it for acquisitions? pay it out as dividends? buy back shares?). Most importantly, I want to see whether owner earnings are growing at a healthy clip, staircasing in an up and to-the-right trajectory, and being used in shareholder friendly ways. 

Then I calculate the compounded annual growth rate of the owner earnings AND CUT IT IN HALF to build a margin of safety into my assumptions as early as possible. I apply that growth rate to the last full year numbers from the business. If it were to grow at my calculated rate, I want to know what its overall owner earnings will be five years from my initial investment. 

Let's just go ahead and use Hasbro as an example. Using fiscal year 2010 numbers, I calculate its owner earnings to be $360 million. Its compounded annual growth rate since 2003 has been 10.1 percent, so I'm going to use 5.05 percent in my conservative estimates. Meaning, at the end of 2015, its owner earnings would be $460 million. 

I assume that after paying dividends and reinvesting back into the business, excess cash will go to share repurchases. Without getting into all of those details now, my calculation is that Hasbro's outstanding shares would drop from 129 million today to 108 million at end of 2015. A quick bit of division and I see that Hasbro would generate 4.24 in owner earnings per share at the end of five years. 

Now I apply a multiple that those earnings. Most value investors would be aghast at this practice. After all, you should never try to guess the mind of Mr. Market! I find it no more arbitrary than trying to calculate business performance out to infinity by running a formal discounted cash flow analysis. Hasbro's current multiple is about 12. A quick look at its historic owner earnings multiple shows that it has ranged - on the low side - from 11.8x to 36.9x over the past nine years. That makes me feel comfortable that 12x is plenty conservative for my margin of safety needs. I'll use it.

So 12 times 4.24 gives me a conservative share value of 50.90. Now I add back accumulated dividends, assuming that Hasbro will continue paying out at its recent rate of 36 percent of owner earnings. I think that's pretty conservative since it means the five year dividend growth rate will only be about five percent (the same as owner earning growth rate for obvious reasons) instead of its historical 26 percent compounded rate. 

The dividends are 6.41 plus the share value of 50.90 gives me a total value of 57.31. Starting at about 33 per share today, that means the value will appreciate a total of 73.7 percent or on a compounded annual basis of 11.7 percent.

Now, where should we start quibbling about the errors in calculation or thought process? They are plenty. The point, however, is to make a quick and dirty stab at valuing the business five years hence using conservative assumptions. Each step of my process is meant to lead to an easy way to screen out investment candidates that don't merit more of my research time. Hasbro passed the early tests, meaning I thought it worthy of investing an hour to push it through this margin of safety stress test.

What do I want to discover from this stress test? That the conservative inputs suggest the likelihood of a satisfactory return for my investment. I'm not looking to thread the needle with businesses promising only  marginal upside after making ambitious assumptions of their performance. I'm looking for meaningful compounded growth after chopping their growth prospects down to earth.  As a prominent investor once said (and I paraphrase), it should be so obvious you could drive a truck through it.

Rough calculations suit my needs at this stage.

Hasbro shows promise of about 12 percent compounded growth in this test. Since the business has modest needs for reinvested capital, the bulk of the benefit comes from using owner earnings to payout investors via dividends and share repurchases. I prefer to see a clear and easy path to 15 percent compounded returns, but my impression is that Hasbro is of high enough quality that I can invest my time and take it to the next stage of research.

Walmart (WMT): Part Six - Is Walmart Cheap?

Last time we considered that Walmart market value has gone sideways for at least eight years. If we define owner earnings as the cash available for the benefit of equity owners either directly (e.g., payouts through dividends or share buybacks) or indirectly (e.g., reinvestment into profitable business growth), we can see that management has increased that from about $7 billion in 2003 to about $18 billion in the most recent full fiscal year. That's over 13% compounded annual growth. 

All the while, the stock price has gone from a peak of nearly $64 in 2003 down to about $50 today for a compounded annual SHRINK rate of 3%. So, it's clear that the share price and the value of the company have been at a disconnect. How does that relationship look today?

   

On the basis of owner earnings, at $50 per share the company is …

1. Very cheap on an historical basis. We saw this in the last post where Wal-Mart’s owner earnings multiple has dropped each year from 40x in 2003 to about 10x now, making it the cheapest it has been over the entire eight-year period.

2. Cheap to very cheap on a relative basis. Based on my rough estimates of owner earnings for some other key retailers, Wal-Mart is trading below all of them. Home Depot is currently valued around 15x owner earnings, Costco about 27x, Dollar General is 14x, and Target is 9x.

3. Pretty cheap on an absolute basis. 10x owner earnings implies that Wal-Mart produces a 10% yield for the benefit of owners based on the price they would pay to own its stock today. For my tastes, screaming cheap for a good company about 15% yield (~7x), but for great companies with strong prospects I can stomach as high as 20x owner earnings (5% yield).

All modes of cheap, however, are not created equal. It makes me think of the quip attributed to Woody Allen, "Just because I'm paranoid doesn't mean they're not after me." A business can appear cheap on a variety of measures and, more likely than not, it's cheap because it's legitimately not worth more than its price. There is a special danger inherent to making comparisons when trying to establish the value of a business, whether you're comparing it to itself (historical) or to similar companies (relative). Perhaps it appears cheap because it has exhausted all growth prospects that helped speculators rationalize its 40x valuation eight years ago. Or perhaps it ceded its competitive advantages to other retailers and now must fight in value-diminishing ways to maintain its market share. Reasons abound for cheap value matching cheap price.

That's not to suggest there is no benefit to reviewing historical or relative measures of cheap, but they must be steeped in two additional thought processes to make sure they aren't just leading you into a value trap.

The first is a relatively simple question you can ask yourself and treat it like a point on a safety check-list: Is the business cheap on an ABSOLUTE basis?

The full implications of that question are more complex than the check-list concept might suggest. It's largely a measure of placing the business in a state of suspended animation - taking a snapshot of where it stands today - and evaluating it as if it were an interest bearing investment. Take owner earnings, compare them to the price at which you're buying the business, and equate the percentage to interest paid against your principle investment. If the rate satisfies your return requirements, you can check the box.

For example, with Walmart trading at 10x owner earnings we can say that buying the business for $50 yields you $5 in earnings. If you return requirements are 10% or less, you have satisfied that checklist item.

Hypothetically, you could  stop here if you had good reason to believe Walmart will continue operating in AT LEAST as good a state as it currently exists.  You can say it's cheap on an absolute basis. But investing is rarely that simple. The second thought process can take you deep down the rabbit hole...

What does the future hold for this business?


The essence of investing is divining the future. Even if you're trying to check the simple box of whether a business is cheap on an absolute basis, you're making implicit assumptions that the business will continue generating the same amount of owner earnings into the future. That assumption requires further assumptions about access to and use of capital, competitive landscape, size of the market, etc. in what can seem a forever branching sequence of questions and even more assumptions. I'll avoid any attempt at the discussion here, but it's no stretch - when considering how variable A affects variable B changes variable C, ad infinitum - to say a business is akin to a chaotic system (using the physics definition) in which specific outcomes (the future) are by definition unpredictable and therefore unknowable. You will get it right from time-to-time, and perhaps even more often than not. But unless you have a reliable process for approaching it, you have no basis of saying your success (or lack thereof) is based on anything more than pure chance.

What is a reliable process for attempting to divine the future? One that confesses extreme ignorance of precise outcomes and gears itself instead to avoiding big mistakes. One that looks for advantages and still makes conservative estimates of future performance. One that eschews lazy-minded optimism in favor of a wide margin of safety.

Next, we'll discuss a way to think through margin of safety in valuing Walmart.

Walmart (WMT): Part Five - Sideways Action Deflates the Value Balloon

In its fiscal year 2003, Walmart generated about $7 billion in earnings that went to the benefit of its equity owners. It paid a modest dividend, plowed the rest back into the business, and then borrowed another $3.8 billion to invest even more into its growth.

It was good times for the world’s biggest retailer. The company’s market cap hit $283 billion – more than 40x those $7 billion in owner earnings – revealing investors’ enthusiasm about the business; about their belief that it was going to grow and grow and grow.

And grow it did. Revenue has jumped from $247 billion to nearly $422 billion. It has reinvested over $90 billion to build new stores, strengthen its already formidable distribution and technology edge, and expand internationally. And those owner earnings have compounded at a rate of 13.5% each year since 2003, reaching $18 billion this most recent fiscal year, 2011.

Surely those investors who saw their digital certificates of stock blink up to $63.75 in 2003 have made out like bandits, riding the impressive operating results wrought by Wal-Mart’s management over the decade. Right?

No.

As I write this, Wal-Mart’s market value is about $181 billion. That’s right. Despite years of business expansion, compounded owner earnings, dividends paid, and shares repurchased, the market value of the company is 35% less now than it was then.  Does this make sense?

Well, yes. It pretty much does.

Paying 40x owner earnings for any company is hard to justify. Wal-Mart, the great business that it was (and is), was overpriced.  What tends to happen in these cases is one of two things.

One, something about Wal-Mart’s operating performance, the stock market in general, the world economy, etc. spooks investors and sends them running for the exits, popping the inflated balloon that was Wal-Mart’s stock price.  This is common for hot “growth” stocks where the value depends on optimistic (nay, drug-induced?) assumptions of their continued growth. When circumstances no longer allow speculators to delude themselves, they panic and send the stock price into a nosedive with their selling. Don’t be surprised when you see this happen to…salesforce.com (CRM) selling at 191x its net earnings, Dunkin’ Donuts (DNKN) selling at 179x, or even a powerful force like Amazon.com (AMZN) selling at 83x.

Two, investors avoid an overreaction, but let the air out of the balloon one small deflating puff at a time. There is no panic, but no new buyers emerge for the stock at the high valuation and existing owners – perhaps realizing this, or perhaps recognizing that they bought too high, or perhaps from boredom that the stock price isn’t moving – start a slow sell. Though it lacks the excitement of a pop, the air just gradually seeps out. 

For owners of Wal-Mart at $63.75 in 2003, the process has been slow and excruciating. Things have just gone sideways for over eight years. The high multiple of owner earnings at which investors have been willing to buy the stock in any given year has drifted from 40x to 37…31…23…16x. And today, with a price hovering around $50 per share, Wal-Mart is trading at about 10x its fiscal year 2011 owner earnings of $18 billion (give or take).

So, the question becomes, is Wal-Mart now an attractive opportunity for new investors?