This is one of those inside-baseball questions that the serious, more-than-part-time investors out there will probably enjoy.
Hi, Joshua. I could read your blog all day. Thanks for everything that you do.
When I read your commentary on payout ratios, it seems to focus on EPS payout ratio, or dividend coverage. I don’t understand why you don’t focus on free cash flow, instead. As a corporate accountant, I know how easily EPS can be fabricated or adjusted to be almost any amount. EPS, a GAAP reporting concept, does not pay dividends, but free cash does. Can you please provide either a response or a post addressing this? Thank you, again.
Craig
You’re absolutely right on your insistence to use a cash flow based metric in the ability to fund dividend payouts (as well, I should add, as it being the appropriate starting point for the calculation of intrinsic value). I use a modified form of what has been dubbed “owner earnings” that attempts to approximate cash flow on the base business, stripped of any leverage effects, and distortions caused by growth. It’s derived from the old calculations that became popular back with the rise of finance as a serious discipline, with a lot of the credit going to the folks at DuPont, who really took enterprise analysis to a new level.
You see some form of this referenced all the time; if I recall correctly, I think even the media’s favorite investor, Warren Buffett, discussed using it as his investment partnerships when he was interviewed by Adam Smith back in the 1970’s after he had closed the doors and focused on his new holding company. Being a corporate accountant, you’ll understand my reasons for preferring it (for those who aren’t, it’s because it immediately tells me the utility I could receive in the form of cash that can be extracted and spent, given to charity, saved, or reinvested were I in total control. Not only does it provide a rough gauge for the utility of ownership, it also puts all assets on equal footing, so it doesn’t matter if I am valuing a hotel in my hometown or a share of common stock for a brokerage account – it’s all about collecting the most, net, risk-adjusted cash relative to what I have to spend to acquire the right to the cash stream).
An adjusted cash flow metric is a much better figure, for those who can read financial statements fluently, than reported earnings per share, both when it comes to determining the stability of a dividend and the true nature of the corporation or partnership. An illustration: Many years ago, I remember reading the UPS annual report and discovering that the year-over-year increase in reported diluted EPS was mostly the result of a change in the way management paid its executives, taking advantage of the accounting treatment of a certain type of arrangement. It’s been a long time, but I think they also changed the discount rate used to value the pension liabilities, and some other small adjustments. UPS is a great business with a very strong franchise, and I imagine they were doing it so they could keep the charts in their annual report in a nice, upward slope, marching ever higher, but I ended up using a lower figure to value the firm and, as a result, didn’t buy the shares. I wrote about it back in 2006. In fact, it made me somewhat dubious as to whether or not I could trust management’s public assessment of the company as they weren’t exactly forthright about the underlying cause of the increase, but rather touted it as something that had to do with their superior abilities.
My Preferred Cash Flow Calculation for Determining Intrinsic Value and Dividend Coverage
I make a few modifications for my own personality and the sake of conservatism, but the basic formula is this:
Reported Net Income
+ Depreciation and Amortization
+/- LIFO Inventory Reserve Adjustments
+/- Accounting Adjustments That Obfuscate Reality
+ Required Working Capital
– Maintenance Capital Expenditures to Maintain Current Unit Output
+/- Adjustment Factor for Overfunded or Underfunded Pension
+/- Adjustment Factor for Other Non-Avoidable Contingent Cash Inflows or Outflows
= Stable Cash Extraction Value for an Owner Opting for a 100% Dividend Policy of Any Earnings Not Required to Maintain Current Competitive Position in the Industry
Then I compare that value, if I could own the entire enterprise, lock, stock, and barrel, to the net capital required to be invested in the business, both equity and total, as a mechanism for determining the quality of the firm’s existing operations, factoring in things like durable consumer brands that would be almost impossible to displace or physical advantages that competitors can’t replicate (e.g., possession of a key oil field, a cement company being mostly local, etc.), or a hidden asset that makes the numbers somewhat inconsequential (e.g., if you were buying a farm on top of a natural gas well that no one knew existed, it would be somewhat foolish to value solely the cash flows from the corn and wheat, without factoring it what you are going to get from the energy asset that you can monetize) which is the art part of it.
Owner Earnings, or Cash Flow, Is a Much Better Figure Than Reported Earnings Per Share
At that point, were I satisfied with the type of business, I would then look at the capitalization structure, and any potential dilution from stock options, outstanding warrants, convertible securities, or other source, and calculate the worst-case per-share stable cash extraction value. I would then value the company and determine the various return ranges most probable given a cost outlay today at a given price. For the sake of conservatism, I opt for the most senior security in the hierarchy with the greatest potential maximum theoretical payoff (e.g., it’s rare, but during a crash, you might get into a situation where some small bank out in California is a steal, but you can get convertible preferred shares yielding 15% dividends with a lottery ticket attached in the form of the common stock – this sort of thing happened in 2008-2009 when there were mass liquidations taking place, and sometimes lasted only a few days or weeks).
[mainbodyad]As for future growth plans, I tend to look at management’s track record and ability to put retained money to work at rates of return at least equal to those generated by the existing businesses. If I’m satisfied, I’ll use that information, look out 5+ years, and attempt to come up with a conservative range for where I think earnings and dividends will be. My task is then to make sure my family’s collection of assets is one that is not only safe in the long-run (short-term volatility doesn’t enter into the equation as I avoid debt and derivatives for the most part, giving me the freedom to wait out unfavorable conditions for years), but likely to produce the greatest net earnings and dividends 60 months from today. What makes it a bit more difficult than it sounds is trying to account for the leveraging effect of deferred taxes; you can’t just switch from an investment that looks like it will be earning 8% to one earning 10% because you may end up in a worse position after accounting for your reduced capital net of taxes, transaction fees, and other considerations.
Why I Use Reported Earnings Per Share Instead of Cash Flow In My Illustrations
Why, then, do I use reported EPS instead of the adjusted cash flow figures when illustrating concepts?
- It’s faster
- It’s less scary to a new investor. I’m trying to ease them into thinking of stocks like real businesses and you can use it as a sort of rough proxy without having an advanced knowledge of GAAP.
- It lets me focus on whatever it is I am trying to explain without a lot of distractions (e.g., walking through the opportunity cost differences between PepsiCo and Wells Fargo awhile ago let me talk about opportunity cost, not whether or not I think the development in the loan book is going better or worse than expected, or whether I agree with the depreciation schedules of the new bottling plant in India or something).
- Generally speaking, a broadly diversified collection of assets based on reported EPS should still perform in a correlated way with the underlying owner earnings calculation. If you have a portfolio of 30 stocks, it’s probable that one company depreciating too slowly over here is going to be made up by another firm underestimating the future rate of return on some other project over there.
For those who want to use the more complex figures, I wrote the guides to analyzing the income statement and balance sheet as an introduction to the topic.
Dividend Track Records Can Be Used as a Sort of Layman’s Guide to Cash Flow or Owner Earnings
For someone who doesn’t want to bother with learning advanced accounting, there is sort of a cheap and dirty backdoor hack that can do most of the heavy lifting. As the saying goes, you can’t fake cash. When a company pays a dividend, the money is either deposited in your account or it’s not, and once it’s yours, it’s yours. It acts as a sort of rebate on the purchase price.
[mainbodyad]If a firm has a long track record of rising dividends, far in excess of the rate of inflation, and you instinctively know that the brand has staying power (e.g., Clorox or Coca-Cola), you can look at the long-term historical range of dividend yields, and only buy when the dividend yield is in the top quartile compared to its long-term record. It’s not a perfect approach, but taken on a whole, it has some merit as the net effect is often to replicate the same sort of owner earning calculation you would get if you had the skill to perform an advanced analysis. You also have to make sure that the dividend payout ratios aren’t climbing higher.
For example, if Coca-Cola were yielding 4%, and the dividend payout were 50%, based upon a century of analysis, in almost all circumstances short of some unknown variable for which we are not presently accounting, it’s got a much better than average chance of turning out to be a fantastic long-term holding.
There is actually a niche approach to investing that follows this line of reasoning (and has performed quite well, historically), based on a tome penned more than quarter-of-a-century ago called Dividends Don’t Lie. It has recently been updated in a new book called Dividends Still Don’t Lie. It’s actually shocking how closely the valuation figures produced by their relatively simple methodology end up matching my own. The only downside of the approach is it doesn’t permit you to take advantage of some great opportunities, such as if you saw Chipotle in the early days rolling out across the country or Apple when Steve Jobs returned. Still, that’s fine. In investing, it’s not so much the wins that matter as it is avoiding losses. Compounding can perform miracles if you just avoid permanent losses of capital. For the regular investor, I think this is a safer, more intelligent way to behave, even if it means passing on some businesses you might otherwise buy.
Reader Comments (24)
Comments are presented chronologically, with replies indented beneath the comments to which they respond.
Gilvus
September 5, 2013
TL;DR: you water it down so new investors don't have intellectual hernias 🙂
Matt
September 5, 2013
Could you give an example of what would count as +/- Accounting Adjustments That Obfuscate Reality and +/- Adjustment Factor for Other Non-Avoidable Contingent Cash Inflows or Outflows?
Also, when you say "If you have a portfolio of 30 stocks, it’s probable that one company depreciating too quickly over here is going to be made up by another firm underestimating the future rate of return on some other project over there.", wouldn't depreciating too quickly result in depressed current earnings, and thus imply a higher owner earnings (The assets would be depreciated faster than its useful life, which means expenses are incurred way before the replacement needs to occur)?
Joshua Kennon
September 5, 2013
Replying to Matt
1. A lot of these are industry-specific.
If I were looking at a property & casualty insurance company, how the firm treats the accounting for deferred policy acquisition costs is going to have a fairly large influence on the short-term GAAP earnings (hence one of the reasons I almost always value insurance companies using the NAIC statutory accounting rules, instead, as they are far more draconian and cut through a lot of the nonsense as they were designed and used specifically for and by insurance companies).
In some situations, real estate companies will capitalize the interest they spend on a project in development, treating the cost as an asset on the balance sheet. In this case, that asset really represents money already spent. It seems bizarre, but it makes sense in the entire context of things. The degree of capitalized interest would factor into my analysis of such a firm.
The same goes for software. Large software outlays can be capitalized as an asset, even though they are an expense and have no liquidation value, requiring an adjustment in the quality of the book value and / or the income stream, especially if it is a large project.
The pharmaceutical business used to be penalized under GAAP as a result of how research was treated, but a lot of that has been cleared up in the past decade or so.
If I were looking at a bank and I thought the reserves being set aside for loss development were too conservative or aggressive, I would make an adjustment.
A company could be sitting on a piece of real estate worth tens of millions of dollars carried on its books for next to nothing. That is worthy of an adjustment on the balance sheet.
Firms with contingent asbestos exposures would be an example of a potential outflow that would need to be considered, to some degree, in the analysis, as would a company likely to receive a large cash settlement or proceeds from divestment of an undervalued asset that has been on the books for decades.
It's a myriad of small things like that. They can make an enormous difference depending on the industry you are studying.
2. Yes. It should have read "slowly", not "quickly"; thank you for catching that. It was a typo left over from a modification in the draft.
Matt
September 6, 2013
Replying to Joshua Kennon
For the first category, would my understanding be correct that the items like deferred policy aquisition costs, capitalized interest, software, and research items all fall under the theme of some sort of classifying between operating and capital expenses? Do these adjustments matter if the yearly expenses are stable (not increasing/decreasing)? (Capitalizing an increasing cost would understate earnings, while in a scenario with stable expenses, this would be a wash, just like depreciation/capital expenditures for a mature company in the long run).
How would a hidden asset like valuable real estate booked at low values affect earnings? I can understand how it can affect the value of a company, but shouldn't this be accounted for by adding the value of the property to the overall fair value of the company rather than stuffing it in earnings and extrapolating from there?
Joshua Kennon
September 6, 2013
Replying to Matt
1. Many of them fall into that category (operating/capital differentiation). Many also fall into some sort of analysis of the intelligence of various reserve estimates (e.g., a tool company that provides a lifetime warranty - have they under or over reserved for the warranty costs?; a bank that has a book of commercial real estate loans - have they under or over reserved for the bad debt?)
2. Do they matter when stable? Yes. Will that have an influence on intrinsic value? No, not in the given period. Do you still measure them in case they change in the future and are aware of something different happening? Yes.
3. Yes. It wouldn't show up in the earnings unless you thought monetization was inevitable or going to happen within the next few years. Otherwise, you'd add it on the intrinsic value figure to come up with a net asset value (NAV) for each share of the business. A portfolio of holdings where you get good earnings, backed by the insurance of strong net asset values, can be a very satisfactory undertaking (there is a firm in New York that has specialized in it for decades called Third Avenue; their chairman, Martin Whitman, is a legend in the field).
4. The chapter you mention from Damodaran's book will give a good general idea of some of the things to think about, but it won't get you to fluency. You need to know the accounting of the cash flow statement and how it interacts with the balance sheet and income statement. That's going to require accounting textbooks and a lot of exercises. You will also want to check out a book by forensic accountant Howard M. Shilit called Financial Shenanigans, that explains how to detect accounting fraud in financial statements. By seeing how the numbers can be manipulated, it might help you understand where to look to measure that which you might conclude should be measured differently.
Matt
September 6, 2013
Replying to Joshua Kennon
Ah that helps explain things a bit more. Thank you for the detailed responses and the book recommendation. I really appreciate your generous and insightful help!
joe pierson
September 6, 2013
I would like to ask can't cash flow be fudged short term like EPS? (selling inventory without replenishing it, holding off accounts payable, or aggressively demanding accounts receivable)? All this generates real cash.
Joshua Kennon
September 6, 2013
Replying to joe pierson
The metric I used won't be influenced by any of the things you mentioned (hence the reason I use it). It focuses on cash earnings power, not the cash that can be accelerated or decelerated into a specific period.
Generally speaking, though, whenever you attempt to manipulate cash flow, it shows up somewhere. It's much harder to fake.
So to answer your question: No. Not really.
To use your examples:
1. If you sell inventory without replenishing it, the average inventory per dollar of sales is going to fall without explanation.
2. If you aggressively demand accounts receivable prepayments, your average receivable balance outstanding relative to sales is also going to fall, as is the average days outstanding, both of which would be calculated by any serious study of the enterprise from the three financial statements.
Again, generally speaking, the only real way to fake cash flow under the GAAP system where the rules are being followed is to outright lie or commit fraud. It can't be manipulated nearly as easily as the other metrics so the best you can hope to do were you a dishonest manager is moves like using acquisitions to make things too hard to understand, use a handful of tricks to move financing cash flows into the operating cash flow column, etc. You can use it to see how much of the current outlays are funded by profit, retained earnings, and debt. That's why, if you know what you are doing, the cash flow statement is indispensable. You can use it to see whether a project is delivering real increases in purchasing power or merely serving as a sort of quasi-corporate bond (e.g., AT&T versus Clorox).
If you aren't sure how to do any of this, a very good place to start would be to read the forensic accounting book Financial Shenanigans: How to Detect Account Gimmicks & Fraud in Financial Reports. It's the best layperson explanation I've ever come across in my reading. It has an entire section on ways to spot problems in operating cash flow changes.
joe pierson
September 6, 2013
Replying to Joshua Kennon
" the average inventory per dollar of sales is going to fall without explanation."
Is it correct to conclude that would be reflected in the
"Maintenance Capital Expenditures to Maintain Current Unit Output"
term of your cash flow equation?
Joshua Kennon
September 6, 2013
Replying to joe pierson
Let me back up for a moment and explain what is happening so it may answer your question, albeit indirectly.
The formula I use looks as the maximum sustainable cash extraction value for a firm for a given year. If you examine a period of years (Graham was fond of at least 7 as it was likely to include one or more recessions, on average, to give you an idea of performance during a down economy - anything longer than that and it is arguably no longer the same firm due to market changes, employee turnover, and other factors), these sort of short-term shifts don't matter. A dishonest management might be able to shift cash from quarter-to-quarter. In extremely rare, almost unthinkable circumstances, they might be able to shift a meaningful amount unnoticed from year-to-year. They can't keep up the charade much longer than that short of outright fraud.
The formula itself doesn't capture it in any given single year because the way the three financial statements interact together makes it doesn't need to capture it as management's best efforts to accelerate or reduce cash flows are mostly going to be washed out over a multi-year period examination, which is how all but turnaround situations should be analyzed. I would almost never buy a business based on just a single year's financial statements.
Instead, once you've valued the company (or rather, as you're valuing it, as the pieces of the puzzle become clearer), you go back and do a risk analysis. One of those steps involves looking for signs that things aren't right; you look for evidence of accounts payable being pushed to hoard cash, or short-term liabilities creeping up at risk to the firm. You look for evidence of inventory stuffing. Then, if you find it, and is it more than questionable, you do not buy the business at any price (unless you had a large organization and the ability to use your own team of forensic accountants to investigate - but we're talking from the perspective of an outside, minority, passive shareholder here). You cannot "value away" a lying management. You run in the opposite direction. It instantly negates the valuation from the first step, the formula, and gets the business thrown off the consideration pile.
joe pierson
September 6, 2013
Replying to Joshua Kennon
"On the other hand, a guy could theoretically screw with EPS for decades "
Ah, that was the nugget of info I wasn't aware of. Thanks for the detailed explanation.
BidAskDividends
September 6, 2013
Great article, great explanation. I'm a huge fan of Cash Flow over EPS and you hit on all the points why, as well as including some additional ones I had not thought of.
Adam
September 8, 2013
Joshua, what do you mean by "+ working capital"? Do you mean changes in working capital, or growth WC? Isn't that/shouldn't it be taken care of by a separate growth calculation (growth capital)? Your thinking sounds very much like Greenwalds, I assume you've read "From Graham to Buffett & Beyond"?
Joshua Kennon
September 9, 2013
Replying to Adam
Every business has a specific amount of working capital that must be tied up in it for it to maintain operations and keep the lights on at all times. While this money belongs to the owners, they will never be able to extract it until the company goes into liquidation, which may be a century or more in the future (e.g., an original shareholder of General Electric still hasn't seen it happen). As it cannot be extracted from the business without harming the firm, I deduct the entire amount of these restricted funds as my objective is to determine how much net, surplus fresh capital is going to be generated that the owners could take out back, pile up into haystack formations, and dive through a la Scrooge McDuck. The more of that kind of money your business is throwing off, the richer you're going to get.
The result of this approach, focusing on extraction value without hurting the business, is that two companies - one a steel mill the other a software firm - each earning $10,000,000 a year would have radically different valuations as, in the first case, an owner would have to plow most of his profits back into new equipment, raw materials, et cetera, while in the second case, it's all surplus that could be withdrawn and spent on cars, houses, charity, or whatever. The GAAP accounting profits may look identical, but the real, owner earnings are anything but. It's the same philosophy and conservatism applied to the working capital account.
General rule: You can't touch it = Deduct it from the valuation
Stanley
March 5, 2016
Replying to Joshua Kennon
Correct me if I'm wrong, Joshua, but if you meant "deduct the entire amount of these restricted funds [e.g. Working Capital]", then shouldn't the formula be "- Required Working Capital" instead of "+ Required Working Capital"?
peterpatch79
September 9, 2013
Hi Joshua,
Thanks again for the great articles. I like how you are opening the kimono a little bit here.
A couple of questions about your adjusted cash flow
1. "- Maintenance Capital Expenditures to Maintain Current Unit Output"
What do you look at to get an estimate of this? For example Pepsi makes cereal (Quaker Oats) in my hometown. When I toured the factory as a school boy I noticed that the building was mostly original (100 years old or so) but the manufacturing machines were state of the art with X-rays, metal detectors and air hoses that shot the cereal boxes off the line if they were out of control standards. What is your thinking process for coming up with a reasonable cash flow for this type of thing, knowing that unknown future technology could be necessary to maintain the competitive position.
2. "+/- Adjustment Factor for Overfunded or Underfunded Pension"
What rate or range of rates do you think companies should be using as a return on investment for a DB pension? Do you have a hard number or is it more formulaic based on underlying return rates that the market is offering (like 2x 30 year treasuries or some such).
Joe D.
September 9, 2013
About those "intellectual hernias," the last couple articles showing how you valued autozone and calculate cash flow made me conscious of how little I know about valuing companies and investing. Normally you make things very basic, and I think that made me think I knew more than I did, or I could make investments one day via "crunching the numbers." I've read many investing books, more than most people with a demanding full time career and kids, but seeing how you approach investing shows me that I am still a toddler trying to play against professional athletes should I try to invest in individual companies. Maybe one day I will get there, but I would always be afraid of missing something since I don't see myself getting to a point where I can factor in all the nuances of company valuation. Perhaps valuation is easier than it sounds, but I seriously doubt it. I am growing eager to invest with with you however. I think this site has built you enormous trust and credibility with your readers.
Stephen H
August 6, 2015
Replying to Joe D.
Joe -
Yeah, Joshua has a way of making you think half your brain died, not on purpose, he is in the top league of people writing on this subject. But he has written some great basics on About.com that making people not familiar with an Income Statement able to understand (myself included).
But the end of this article he mentioned the dividend track record as a way to do a similar albeit simple "intrinsic value calculation". So don't think because the more advanced stuff is out of reach now that you can't or aren't capable of making sound investment decisions. I don't think, using that last model, buying Hershey on a good valuation at a historically high yield will give you a bad result (not a stock tip, just an example). I love this site though.
Jim
September 11, 2013
Have you produced or do you know of any You tube videos
lectures on accounting for investing that you recommend?
Matthew
April 27, 2015
Hello Mr. Kennon. I'm a bit late to the party, seeing as this article is 2 years old, but just wanted to have a few thoughts confirmed, if you so desire and at your leisure. Firstly, can we say that the owner earnings equation is essentially free cash flow, with a few pragmatic adjustments? Or is owner earnings a different technical concept?
Secondly, may we find out how an individual can compute for his personal opportunity cost? For comparing corporate projects, textbooks teach management students to use WACC as the hurdle rate. But for personal investments, I'm thinking of using the following components to reflect my opportunity cost:
1) a "personal" inflation rate based upon a basket of purchased goods built over five years, computed CPI-style
2) a "risk-free" rate based on the investment that corresponds to the timespan of the investment (e.g. if I want to hold a British stock forever like you, I'll factor in the consol rate of 2.5%)
3) a risk premium (e.g. the return of a FTSE 100 ETF - the 2.5% consol rate)
Corey W
May 5, 2015
This is an old post, as such I suppose new comments get buried. That said, it's posts like this that I appreciate. This shows a glimpse into your "process" that many investors don't show. There are a few posts that show rare glimpses into your technical psyche, and through these small bits and pieces I take and ponder for my own philosophies. Thank you for opening up, so to speak. I try to go of a "limited information intake" , where I try to mostly only study things that I know will provide a good framework as I look out at my future. I'm still in my early years of learning about investing, and know I am very impressionable, so I always try to put together the most rational, recession proof base of knowledge that I can. Thank you for your work, and for letting it be a part of my foundation.
"Upon this rock, I will build my church"
Pablo
June 3, 2015
I had a question. I am confused about the add back for the required working capital in your owner earnings calculation? Wouldn't you want to deduct required working capital because the company requires that cash to buy inventory and to pay for pre-paid expenses?
joe pierson
July 13, 2017
Replying to Pablo
Yea, I think that was a mistake.
Stephen H
August 17, 2015
This is good, but would love an example with someone like General Mills. Having a tough time putting it together. Love the site, what a resource!