Comments (36)

9y 
KarateBoy, what's your opinion? Comment below:
Vilma:
EV/EBITDA

Net Debt/EBITDA

Charlie Munger wouldn't like this answer...

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  • 1
9y 
grosse, what's your opinion? Comment below:

A bit of an odd question. Shouldn't it be "you only get two metrics and have to make an investment based on that alone, which would they be"?

Otherwise, the question is like "you've got all the info in front of you, how can you synthesize it best".

My answer to my own question: EVA and P/E

EVA - is this company creating value above its cost of capital P/E - how much am I paying for this value creation

Paying too much for company that will do well in the future will lose you money just as investing in crappy company would.

9y 
John Daggett, what's your opinion? Comment below:

I like (BEST NUMERATOR HERE)/Equity. The problem with all the other ones is that they include debt. This punishes the company for using leverage which is really cheap capital. Furthermore, they treat accounts payable and other non interest bearing liabilities as the same as if they accrued interest.

9y 
KarateBoy, what's your opinion? Comment below:
John Daggett:
I like (BEST NUMERATOR HERE)/Equity. The problem with all the other ones is that they include debt. This punishes the company for using leverage which is really cheap capital. Furthermore, they treat accounts payable and other non interest bearing liabilities as the same as if they accrued interest.

It doesn't "punish" a company, it just looks at total invested capital. Total investment capital is a better proxy for the economics of the business/industry.

Your idea of (BEST NUMERATOR HERE)/Equity completely ignore the level of indebtedness, including all the refinancing risk associated with maturities.

I don't see how any of the metrics above treat "non interest bearing liabilities as the same as if they accrued interest". I think I know what you tried to say, but you do realize that working capital has to be paid back, right?

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  • 2
9y 
John Daggett, what's your opinion? Comment below:
KarateBoy:
John Daggett:
I like (BEST NUMERATOR HERE)/Equity. The problem with all the other ones is that they include debt. This punishes the company for using leverage which is really cheap capital. Furthermore, they treat accounts payable and other non interest bearing liabilities as the same as if they accrued interest.

It doesn't "punish" a company, it just looks at total invested capital. Total investment capital is a better proxy for the economics of the business/industry.

Your idea of (BEST NUMERATOR HERE)/Equity completely ignore the level of indebtedness, including all the refinancing risk associated with maturities.

I don't see how any of the metrics above treat "non interest bearing liabilities as the same as if they accrued interest". I think I know what you tried to say, but you do realize that working capital has to be paid back, right?

I think we have different assumptions about market efficacy/inefficacy. I think that you are assuming that the return of any type of capital is proportion it to its risk. I commend you for learning what your professors teach. I am assuming that most investors are lazy bites who would rather watch YouTube than read though all of the disclosures before investing. Whilst the vast remainder of investors allow their emotions/hormones to direct their investment toward high risk moderate return investments because they are too lazy to read the disclosures, and they lust for money and its rewards. The latter group spends most of their time watching YouPn instead of reading the disclosures.

As far as non interest bearing liabilities go, I would gladly borrow all the money in the world to invest it in t-bills if someone would lend it to me.

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Best Response
9y 
Gray Fox, what's your opinion? Comment below:

I think this has the potential to be an excellent, excellent thread because it requires talking about how an individual thinks about a business and what pieces of information are truly important. I would love KennyPowersCFA, BlackHat, Mr. Pink Money, and the guy that is obsessed with preftige to contribute as well.

To get the ball rolling, I'll add a little more detail on my choices.

  1. Unlevered FCF/EV. I would define unlevered free cash flow as EBITDA - maintenance capEx. This hits the company for the debt load in the denominator rather than the numerator which is much more sensitive. I work with equities and try to invest in high quality businesses so I'm generally not too worried about a company being insolvent. Maintenance CapEx requires a bit of subjective analysis. Some companies will try to break it out for you, but you should never trust the numbers they give you. I try to use conference calls, segment breakdowns in the footnotes, and general industry background to get this number. A lot of times acquisitions can be maintenance CapEx as well. Tech companies that choose to go out and buy IP or talented engineers rather than do it themselves can call it growth CapEx, but in reality its maintenance. When ORCL rolls up 5 different cloud companies a year, they can call it whatever they want but they need to do it to protect their competitive position. Autos, energy companies, industrials, material businesses etc tend to have very high maintenance CapEx needs. Consumer products have very low maintenance CapEx needs. This goes without saying, but EV should include any kind of pension deficit, asbestos/litigation liability, etc that the company has to fund, net of any tax relief they may receive.

Giving a company credit for "growth CapEx" can be difficult and often relies putting some faith in management. I try to look at the history of capital allocation, their incentives (cash comp vs. ownership, whether PSUs depend on revenue or cash flow), and the frequency of large projects. To give two opposite end of the spectrum examples I'll use HPQ and BRK. After the $11bn fart into the wind that was the Autonomy deal, the huge EDS writedown, the Compaq writedown, etc you would have be to beyond stupid to give HPQ credit for a deal or large capital project. On the other hand, if Warren Buffet says BRK did 2.3bn in bolt on acquisitions last year that were accretive, I'll take his word for it. He has a history of being the greatest capital allocator in the world and the guys that run the subsidiaries there generally have sterling long term track records and excellent incentives.

  1. ROIC: I would use the same numerator as above "unlevered FCF" and the denominator would be the sum net working capital, intangible assets, and PPE. I generally exclude goodwill unless it is a situation where goodwill trumps everything else and makes some sense. Greenwald's Value Investing book does a good job of talking about growth within the franchise and I think ROIC is really indicative here. Look at tobacco companies. They all have major working capital deficits which is a free source of float. The only intangible assets are the brand names and those often aren't carried on the balance sheet because they weren't picked up in an acquisition. There is a minimal amount of PPE. On the other end of the spectrum look at the telecoms. They have an absurd amount of PPE that has to be routinely maintained and any growth will depend on the ability to expand bandwidth which means huge amounts of cash outlays. Autos are instructive as well - the plants are incredibly PPE intensive and there is a large outlay into intangible assets as well. Autos are also unique in that there is a huge amount of distributor inventory. If you are really conservative, you can include dealer/distributor inventory in net working capital. It would help to catch the massive channel stuffing that is going on in the auto sector right now.

I'm sure there are lots of other good metrics out there (I like EVA and the ratio of mgmt cash comp/equity holdings) and am curious to hear what people have to say.

9y 
KarateBoy, what's your opinion? Comment below:

I agree with the above. However, I think taking out goodwill when measuring ROIC is debatable unless you think the company will never do another acquisition again. After all, goodwill is a function of capital deployed and is likely indicative of incremental ROIC.

At my new shop we use P/B as a screening tool and conduct thorough NAV analysis.

I find this approach much more tangible - forgive the pun - than typical multiple analysis as a valuation methodology. At least as a measure of value in a reasonable liquidation scenario.

Measuring the upside is much more art.

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  • 1
9y 
BlackHat, what's your opinion? Comment below:

The variant of this question that I see most often is that you can pick only ONE metric. The answer I always gave and expected in interviews was ROIC. If I had to choose another, I would probably choose FCF Yield (as in [sometimes adjusted] Free Cash Flow divided by Market Cap or EV depending on the company's capital structure...normally we ignore debt since we look only for high-quality businesses that don't really need the debt they hold and the equity piece makes more sense as the sole asset to be valuing the business on), as it's something we take very seriously and have a benchmark for at my current fund for large block investments. Other interesting ones that I like are those that help you evaluate management's ability to effectively put capital to work... so things like Return on Retained Earnings and to a much lesser extent ROE (sometimes huge equity bases are necessary to keep a company in a position of strength, so you'll see someone like TIF have a much lower ROE than some other consumer discretionary and conclude that TIF is an inferior business when the case is simply that you don't understand what that ROE means in context). Or you can always go with the Berkshire Hathaway school of thought and say book value is really all that matters...

I think Gray Fox did a good job explaining ROIC, and our definitions of FCF Yield are very similar as well. I'll at least provide my color on why I like both for the way we perceive the majority of our investments.

ROIC - This helps assess the ability of a company's management to properly scale the business, effectively reinvest capital, and when uFCF is used rather than net income, see how self-generative the company can be in terms of its cash. Low ROICs in businesses we perceive as inherently good can often be the result of some awful capex and acquisition discipline, and sometimes finding an opportunity where a great, typically high-ROIC business makes a streak of bonehead purchases and loses that ROIC, it's a great time to swoop in and try to get a cheap stake in the business and weasel our way into the board room if the board is willing to let it happen. I think ROIC does a great job of assessing management, which is ultimately what the question for us is at the end of the day: is management good at what they do?

FCF Yield - To make it brief, we expect a certain FCF coupon (as my boss calls it) on top of our initial conservative projections of what kind of growth we can expect to see on our investment, and hopefully all-in we can get something compelling enough to make an investment. A company that generates a lot of cash for its price is always going to be extremely attractive and helps build in a further margin of safety, should our efforts to suggest changes with management be less than successful.

I'd write more but I'm exhausted. Definitely a great conversation to have though, as I think we'll get some very different answers from the credit guys and people who aren't as close in style/strategy as Gray Fox and me. We chose the same metrics for more or less the same reasons, but a few different ones related to the passive activist's magnifying lens that we tend to look at businesses through.

I hate victims who respect their executioners
  • 3
9y 
blackthorne, what's your opinion? Comment below:

FCF yield & ROIC...Fox did an excellent job but I'd add ROIC also gives an insight into how well management handles acquisitions & expansions.

One of the most attractive companies we looked at recently was run by mediocre management who timed their capex horribly with cyclical downturns, and compounded this with poor acquisitions. Generated handsome amounts of cash, but this was plowed back into the company poorly. Much value to be unlocked.

Credit guys might focus more on balance sheet, replacement value, etc...but I'd rather calculate these values myself/write them down to a conservative base rather than trust their filings.

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9y 
KarateBoy, what's your opinion? Comment below:

John,

I work at a $10b fund and I have 3-years exp.

My comments about the value of looking at the entire capital base are consistent with others who spoke of ROIC. Looking at capital allocation decisions has nothing to do with how active or lazy investors are, its an analyses of the effectiveness of managements decisions.

I don't think you understand what I wrote. I don't think you understand how and why working capital is extended to suppliers/customers. No one can do what you're suggesting.

Good thread. I think there's lots others can learn.

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  • 1
9y 
Finance_Eh, what's your opinion? Comment below:

Okay, I'll take a shot at this thread. Would love to hear feedback from Gray Fox and BlackHat (I'm only a senior student, but past internships doing credit analysis in HY/Distressed).

As a side note, why not CROIC to the both of you (same formula for ROIC, only you use CF instead of NI)?

My two metrics for credit investments:

(EBITDA - Maintenance CAPEX) / Cash Interest

Most analysts look at EBITDA/Interest and call it a day. Using EBITDA - Maintenance CAPEX gets closer to what cash flow the company can really generate to pay off interest obligations. The cash interest (usually at the bottom of the cash flow statement) shows when the interest is actually paid out. Useful if you're worried for liquidity situations on a quarter to quarter basis.

Debt Ladder (does this count?)

Although net debt/EV is probably the more common answer, I'd argue that I'd rather see a debt ladder. Maturity walls scare me, and I'd like to know when the company has to start worrying about refi'ing debt or when they need to get their situation turned around if they are in a distressed situation.

I wish I could include something looking at the cash balance of the company (which is why net debt/EV might be a better answer), but you only wanted two...

Array
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9y 
KarateBoy, what's your opinion? Comment below:

Couple of points to add

1) ROIC is measured with NOPAT or NOPLAT, not NI 2) Invested capital typically excludes non-interest bearing liabilities

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9y 
BlackHat, what's your opinion? Comment below:
Gray Fox:
KarateBoy:
Couple of points to add

1) ROIC is measured with NOPAT or NOPLAT, not NI 2) Invested capital typically excludes non-interest bearing liabilities

ROIC can use any numerator you feel like.

"Return" can be whatever measure you want to choose to define return. I think both GF and I suggested uFCF or at least FCF as a numerator. NOPAT is just as good as well, and what I use to calculate it tends to be company-specific like any other metric should be.

Also, what's the reasoning for excluding zero-coupon financing? I'd want to use any and all capital the company has had to raise in order to finance their operations, regardless of whether or not they need to service it, and determine how well they can turn it into something greater. Obviously you can exclude things like current liabilities that come as a result of typical supplier financing and what not, but even if a loan was non-interest bearing I'd want to include it, or what am I missing?

I hate victims who respect their executioners
  • 3
9y 
XScash, what's your opinion? Comment below:

For calcs like ROIC and ROE, how do you think about a company that has negative equity due to retirement of treasury shares? I understand that if you calculate using total assets minus the working capital current liabilities you will still get a total invested capital number, but how do you think about that intuitively that they have no book value of equity?

9y 
Gray Fox, what's your opinion? Comment below:
XScash:
For calcs like ROIC and ROE, how do you think about a company that has negative equity due to retirement of treasury shares? I understand that if you calculate using total assets minus the working capital current liabilities you will still get a total invested capital number, but how do you think about that intuitively that they have no book value of equity?
9y 
xqtrack, what's your opinion? Comment below:

In theory, I would probably go with ROIC and expected growth. I think FCF yield would be important for me as well, but in many ways it's similar to ROIC (esp if you use uFCF to calculate ROIC), and between ROIC and growth you should be able to at least in theory rank multiples for similar businesses. For example, you could have a very low return / FCF yielding business, but if it's growing at 25% for the next several years you may still want to pay an obscene multiple for it (see Amazon).

I've never actually calculated ROIC though while investing, so it's definitely more of a theoretical thing for me. Subconsciously, I'm sure I take ROIC into account, but most of the time I just make up a target multiple for what I think the business should be priced at. This makes sense though because I'm definitely not as much of a 'deep value' investor as some of the other guys here.

9y 
ERWB, what's your opinion? Comment below:

I like where this thread is going. Quite a bit of interesting information.

The problem with ROIC is that I feel we quickly eliminate all service-oriented/low capital-intensive businesses for investment albeit I do like the ROIC metric for all other types of business.

9y 
Finance_Eh, what's your opinion? Comment below:

If the business has low capital intensity, your ROIC should be high? I've analyzed a few small-cap service/sales companies. Tended to look at employee metrics (sales/employee, EBITDA/employee) to try and gauge quality.

Array
9y 
Finance_Eh, what's your opinion? Comment below:

Most of us here seem to be in the asset management business where our experience has been AUM is above at least $100M+. Graham was looking mainly at net-nets. If you were to run a net-net screen today, they seem to be mainly micro-caps that you can't get any volume on.

I do look at net-net value sometimes for downside and do net-nets in my PA though.

Array
9y 
blackthorne, what's your opinion? Comment below:

I agree with the caveat that most of us are at l/s funds...colleagues at distressed debt/special situation funds would surely disagree.

But yes-interesting for PA

9y 
Status_Quo, what's your opinion? Comment below:

Sub'd

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9y 
bigblue3908, what's your opinion? Comment below:

Giving this another bump (awesome thread) and also wanted to see what people's opinions are on EVA vs. ROIC and which is more useful. I'm torn on this. On the one hand, EVA tries to take cost of capital into account which is good because it gives a sense of whether the company has a competitive advantage (which is hopefully sustainable for some time). The downside to this IMO is that WACC is so subjective so it takes away some credibility of the analysis. Furthermore, CAPM, which is a component of WACC, is reliant on EMH (if I recall correctly) which makes it not really applicable from an alpha-seeker's perspective.

ROIC leaves cost of capital out of the equation, which isn't ideal, but it seems to be a bit safer in its assumptions. Additionally, companies of various sizes can be easily compared using ROIC, but not with EVA.

Blackhat/Grayfox/anybody else have any input on this?

9y 
monKAY, what's your opinion? Comment below:

Very interesting question.

Given the constraints of only having two metrics to deploy, I think its important to choose metrics that are symbiotic. By this, i mean that i would choose metrics that feed off each other, and combine to give you a picture of the company that you wouldnt ordinarily get from choosing two unrelated metrics.

Now i like where people were going with ROIC and net/debt ebitda. Broadly speaking, this should let you conservatively choose a company which isnt overlevered and delivers a decent return. But these ratios dont feed off each other.

My suggestion is s powerful combination of metrics, which i actually use as my first port of call when screening for stocks. The two metrics are:

EV/IC (enterprise value/ invested capital). This tells you about the market implied valuation ascribed to the business. Its sort of a more inteligent version of price to book. and ROIC/WACC (return on invested capital / weighted avg cost of capital). This tells you about value creation.

Now the fun bit! Divide ev/ic by roic/wacc and you get a single number, which tells you about market implied future returns on capital. Ordinarily a roic/ wacc of 1 should be merited with an ev/ic of 1. Therefore this metric broadly lets you choose stocks that are priced for future returns lower than previously delivered.

The stupidity of this metric of course is that it inevitably leads to a rejection of high quality defensive-growth names, and the promotion of structural shorts! So you have to be careful to use investment judgement along with it...as with any ratio analysis. But broadly speaking, if i had no other metrics, these would be the ones i'd use.

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  • 3
9y 
DDOntheStreet, what's your opinion? Comment below:

Great discussion folks!

I agree with everyone that mentioned ROIC as a key measure to determine management's ability to generate economic value. On top of that, my second pick would be some sort of a "cheapness" ratio.

@BlackHat: I just wanted to ask what is the advantage of looking at FCF Yield as a measure of "cheapness". Wouldn't it be better to look at something more general like EV/EBITDA (adjusted for company specifics) or even P/E? Since I don't really make use of FCF Yield in my investing, just wanted to see your point of view on this. Would companies deemed cheap from a FCF Yield perspective "normally" have a cheap EV/EBITDA as well?

9y 
bigblue3908, what's your opinion? Comment below:

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9y 
monKAY, what's your opinion? Comment below:

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