Archive for the ‘General’ category

Use ROIC, Not EBITDA for Superior Performance

June 8th, 2010

For most industrial entities, return on invested capital (ROIC) represents the most important measure of management ability. Projects whose ROIC exceeds its cost of capital, create value, and as value-enhancing projects continue to grow, the results are reflected in the acquirer’s share price. If the executives in charge of the firm’s assets are consistently able to invest in such projects, it represents the most management- proven technique to reward shareholders looking to build long-term value. Improvements in ROIC are seen in companies able to achieve higher margins, stronger cash flow, and low cost of capital.

For entities which operate on minimal capital, we employ a technique which is based on ROIC, but works better, since, as ROIC approaches zero, it results in extremely large, impractical returns, both positive and negative.

As Oracle Corporation, a very successful acquirer, wrote in its 2009 10K report: “We estimate the financial impact of any potential acquisition with regard to earnings, operating margin, cash flow and return on invested capital targets before deciding to move forward with an acquisition.”

When interest rates are low, corporate planners evaluate taking on projects they might not consider when interest rates are higher. The saving on cost of marginal debt might make such projects worthwhile for equity holders. However, if the cost of debt is variable (i.e., tied to LIBOR) and interest rates rise, the project might become unprofitable. For this reason, that possibility is almost always hedged, allowing the enterprise to eliminate that risk.

Return on invested capital is becoming one of the more widely used analyst metrics. It is of particular relevance however, when under competition with the entity’s cost of capital. By itself, only a vital, but often, partial picture emerges. And for entities or divisions of entities which cannot earn a greater return (on projects) on their invested capital than their cost of capital, its value will decline.

The ROIC is not a measure of security valuation. An entity can continue to accept projects which exceeds its cost of capital, but if its valuation multiple is excessive, its stock could very well decline in the short-run.

Entities which are underleveraged may be denying shareholders a higher valuation if they decline projects having a ROIC greater than the after-tax yield on the excess cash and cost of debt.

Corporate managers evaluate the firm and the business units return on invested capital versus those units cost of capital. Underperforming assets typically have a specific period to improve performance before strategic alternatives are considered. The inability to successfully divest or improve the returns on such assets in a timely manner, meaning, if the unit cannot achieve its cost of capital, could have a negative effect on the entire operations of the enterprise, including its stock price. Management attention is diverted to underperforming units in hopes of turning them around or getting them ready for sale. In addition, the process of divestitures could cause strains on the remaining business segments in need of cash to expand or retool their operations.

The theory behind return on invested capital is to present investors and creditors with an accurate measurement of the cash on cash return management has been able to earn. They need to spend cash to purchase assets in the hopes of a cash return greater than the cost to acquire them.

It is for this reason the analyst should not begin with a GAAP measurement such as net income or EBITDA, but rather free cash flow, in the computation of return on invested capital. Creditors, as with stockholders, expect a cash return, which may not be possible with accounting profits.


Return on invested capital, being one of the central determinants of valuation, has clear advantages over the use of EBITDA.

For example, EBITDA:

  • excludes important tax payments that represents a reduction in cash available;
  • does not consider capital expenditure requirements for the assets being depreciated and amortized that may have to be replaced in the future;
  • does not reflect changes in, or cash requirements in working capital needs; and
  • does not reflect the significant interest expense, or the cash requirements necessary to service interest or principal payments, on debt.

Even in a merger analysis, for which EBITDA was originally intended, its use is limited. In addition to the above drawbacks, it may not be useful since it:

  • does not include share-based employee compensation expense, goodwill impairment charges and other charges which can impact prospective free cash flows;
  • does not include restructuring, severance and relocation costs incurred to realize future cost savings and enhance the operations of the entity;
  • does not include the impact of business acquisition purchase accounting adjustments;
  • does not reflect company sale transaction expenses and merger related expenses, and
  • may include other adjustments required in calculating debt covenant compliance such as pro forma adjusted EBITDA for companies acquired during the year.

To begin analysis of the ROIC metric, we first look at how return on invested capital is commonly defined by security analysts and enterprises, as a search on EDGAR, the SEC database reveals. Here too, as with free cash flow, definitions reported in financial statements differ for filers, making comparability often difficult to impossible. As with free cash flow, many firm’s tailor-make a ROIC definition, attempting to both place themselves in a favorable light, and adjust for peculiarities of their business.

A search through the Edgar database reveals a commonly used definition of ROIC to be:

ROIC=(EBITDA+Interest Income*(1-Tax Rate)+Goodwill Amortization)/(Total Assets-(Current Liabilities+Short Term Debt+Accumulated Depreciation))

National Semiconductor, has an even simpler definition, as spelled out in their 2009 10K: “We determine return on invested capital based on net operating income after tax divided by invested capital, which generally consists of total assets reduced by goodwill and non-interest bearing liabilities.”

Not only does beginning with EBITDA suffer from the shortfalls listed above, it is not a measure of distributable cash and is thus not a measure of real return to holders of equity securities. Excluding goodwill, like National Semiconductor, ignores a real cash outflow for which management is expected to earn free cash flows.


Using free cash flow as a base allows for comparability, uniformity, and offers what ROIC is really supposed to capture, the cash return on cash spent for capital. A more logical definition for ROIC, and one being proposed for analyst adoption to be:

 ROIC= (Free Cash Flow-Net Interest Income)/(Invested Capital (Equity+Total Interest Bearing Debt+Present Value of Leases-Cash and Marketable Securities) )

This more precise definition includes:

  • Intangible assets, as those funds were used to acquire cash producing assets
  • All interest bearing debt, as they too were sold to purchase productive assets
  • Present value of operating leases, as this represents contractual debt in exchange for required assets needed to produce revenue, hence cash flows. To exclude operating leases would be to unfairly boost the return on invested capital and to distort the comparison between companies that buy assets or enter into capital leases and those that enter into operating leases.
  • Since free cash flow is used, it includes the payment of cash taxes and the elimination of other accruals.

We do not add back, as true with EBITDA-based measures, interest income to free cash flow as we are attempting to measure the cash return on productive, not financial assets.

Investors, large and sophisticated to small and naive, with the latter often dependent on, and trusting of the former, often fail to understand the complicated relationship between valuation metrics and return on invested capital.

It is easy to want a simplified approach to investing, such as price/earnings multiple or price/book, but quite another to be able to and understand the bearings behind the numbers, and why so many entities sell for what appears to be an incredibly low valuation multiple or ratio.

In essence, entities having a low return on invested capital or dependent on large capital expenditures resulting in small amounts of distributable cash flows deserve low valuation metrics despite their higher rates of growth in GAAP related yardsticks. This is why many investors are fooled having invested in low P/E multiple companies. It is for this reason we advocate adoption of the return on invested capital metric using free cash flow as a base and, in our model portfolio only invest in entities which have shown the ability to consistently produce an average free cash flow yield in excess of the 10 year treasury yield.

Under the cash flow based definition, goodwill, intangible assets, and all other productive assets which required cash expenditure are counted in the capital base. Operating leases should also be included in the capital base, as they represent a financing decision for capital expected to return cash to the firm. We would not, however, impute an interest charge on the operating leases to deduct from free cash flow, as the entire lease payment is deducted in the computation of free cash flow, as reported under operating activities.

You will find by using the more precise and logical definition of ROIC, to be used in comparison to cost of capital, your portfolio will exhibit lower risk and higher returns.

The Role of Insurance in Security Analysis

June 8th, 2010

Insurance is most often a missing link in fundamental security analysis.

For example, despite BP’s strong credit health (was rated “A” by credit trends) to date, its lack of adequate coverage related to the spill ($1 bil. per occurrence) has caused us to raise our cost of of capital on the firm by 500 basis points. By so doing, the stock has become over-valued at these levels, despite producing over $ 18 bil. in free cash flow during 2008 and $9.7 bil during 2009. Recall our free cash flow model includes the addition of a portion of discretionary expenditures.

If however, the price of crude, a sensitivity analysis reveals, were to rise to $98/bbl, cash flow from operations over the coming two years would approximate $70 bil, when including the added efficiencies of working capital, capital spending, and other discretionary expenditures.

Insurance and Litigation
The role of insurance is an often underappreciated and under-analyzed area of security analysis, which could affect the cost of capital if it was insufficient or its cost grew greater than the rate of growth in operating cash flows.

Regarding uninsured losses, current accounting rules require a company disclose “specific quantitative and qualitative information” about loss contingencies, but does not require them to provide for the fair value impact losses would have on earnings or cash flows. Insurance adequacy is, unfortunately, rarely discussed during investor conferences.

Needing to be uncovered are:
• How is the company protected in the event of major damage to its computer system or warehouse?
• What is their coverage for product liability?
• How are they protected for worst case scenario in the event of a cyber attack, business interruption, due to strike, fire, or power outage?
• Is key man life insurance required to attract a replacement executive?
• Are they attempting to save cash and under-insuring?
• Does the firm require back-up facilities or other redundancies? Are they adequate to allow them to continue providing goods and service?

Murphy Oil had large uninsured damage, impacting free cash flow, during 2006:
Uninsured damages, higher insurance premiums, settlement of the class action oil spill litigation and other hurricane-related pretax costs in the company’s North American operations were $3.0 million in 2007 and $107.3 million in 2006. The hurricane expense in 2007 was caused by a downward adjustment of expected insurance recoveries based on an updated loss limit published by the company’s primary insurer.

Security analysts are typically late in their evaluation of insurance adequacy, relegating their questioning to an event that has already occurred or is forecast, necessitating a review. Not true for the entity itself. For this reason, all large companies have dedicated employees, if not departments, whose sole purpose is to handle the insurance for the organization. If not for insurance, many companies would have filed for bankruptcy, the policies allowing them to collect cash resulting from large lawsuit awards or other catastrophic events. Many firms with facilities on the Gulf Coast of Louisiana would certainly have been out of business had it not been for property and business interruption insurance, resulting from Hurricane Katrina. If an entity not having the resources to cover potential claims exposes its productive capital by being underinsured, its cost of capital should be increased.

Companies have lost large awards resulting from non-awareness of legal liabilities pre-dating their acquisition of a business and for which they did not possess adequate insurance coverage. Other times, new scientific studies determined a company was selling a product which was later found to be unsafe. Such was the case with asbestos, which drove scores of previously financially healthy companies into bankruptcy, including Armstrong World Industries, which did not recognize the problem at its asbestos division at the time it was purchased. In fact, the US Government, at the time Armstrong acquired the company, required their buildings contain asbestos. Armstrong was a very strong and consistent producer of free cash flow, but eventually the asbestos liabilities became too great for their balance sheet and calls on capital. When the lawsuits began, Armstrong did not buy sufficient insurance, estimating they could work their way out of the problem with their strong operating cash flows.

When the price of insurance rises, entities may choose to self-insure part of the risk; the analyst must determine the soundness of self-insurance given a catastrophic event.

Self Insurance: The company utilizes a combination of insurance and self insurance for a number of risks including workers’ compensation, general liability, automobile liability and employee related health care benefits (a portion of which is paid by its employees). Liabilities associated with the risks that the company retains are estimated by considering historical claims experience, demographic factors, severity factors and other actuarial assumptions. Although the company’s claims experience has not displayed substantial volatility in the past, actual experience could materially vary from its historical experience in the future. Factors that affect these estimates include but are not limited to: inflation, the number and severity of claims and regulatory changes. In the future, if the company concludes an adjustment to self insurance accruals is required, the liability will be adjusted accordingly.
Source: Bed Bath & Beyond, 2009 10K


The marketing and sale of our products may involve product liability risks. Although we currently have product liability insurance, we may not be able to maintain our current coverage at an acceptable cost, if at all, and there is no guarantee that our insurance coverage will be adequate to meet all types of product liability claims we may encounter. In addition, our insurance may not provide adequate coverage against potential losses. If claims or losses exceed our liability insurance coverage, we may go out of business.
Source: ecoSolutions, 2009 10K

Most companies have key man whole life insurance on its top executives. Such policies are a tax deductible expense while the cash surrender value most often grows significantly over time. These policies belong to the company, and, as such, their cash surrender values are placed on the balance sheet, although the amount is often hidden with “Other Assets.” This cash can be called on by the entity at any time, if needed, but normally is used to fund key executives retirement benefits.

Not only must the current adequacy of insurance be considered, so too must the risk of litigation that, if took place, would result in a weakened financial condition. Some industries are, by their nature, more subject to lawsuit, while other industries may evolve to become of a higher risk. An increase in such risk is not to be taken lightly, as was seen by the toy industry during 2006 when lead paint was found in many of their products, resulting in free cash flow that could not be reasonably estimated. As was discussed earlier under “Contingent Liabilities,” a thorough review of such prospects (including adequacy of product liability insurance) needs to be explored.

If legal costs exceed, or are expected to exceed 5% of normalized (3 or 4-year) cash flow from operations, a penalty is assessed. If, in the opinion of the analyst, an existing lawsuit, or the threat of one for which the analyst believes has merit, which will result in a payment of greater than 5% of normalized operating cash flows, a penalty is assessed.

Potentially large payments which could emanate from manageable small lawsuits for which a payment has been made would result in a large penalty. Often, however, a firm is reluctant to discuss payment associated with a lawsuit to discourage publicity.

Insurance inadequacy will penalize cost of capital, the amount dependant on the risks involved. Firms that under-insure workers compensation are especially at risk.

Cost of Capital (Risk) Increased Again Last Week

June 6th, 2010

Despite a fall in the cost of debt and common valuation multiples, like P/E or Price/Free Cash Flow, the cost of equity capital again rose this past week.

Many analysts and investment strategists have, over the weekend, quoted a low valuation multiple, as reason for hope of a quick equity market rebound. We doubt this will be the case as the cost of equity is a much more reliable indicator than the valuation multiple-think back to March, 2009, when financial markets rebounded as the cost of equity was falling, many months prior to an actual impact on those factors which reflect upon valuation measures.

It is difficult for us to understand why the credit measures we have been preaching for so long have not received more financial press, but are hopeful, when my text is released, devout followers will be reading more on the denominator of the discounted cash flow model. As we now so coldly see, earnings projections has its limits.

As written last week, neither earnings or free cash flow are as strong as being reported, and thus, combined with higher risk, is not conducive for an environment under which investors should feel confident regarding future distributions.

Investors Overlook Cost of Capital To Their Detriment

June 4th, 2010

Simply put, the cost of capital is the rate investors demand for use of their cash. This rate will, of course shift, depending to whom they are lending or where they are investing, as well as the economic setting.

For the firm, if managers are able to invest in assets or projects which can consistently earn a rate in excess of the rate they must pay for the use of capital ( its cost), it is creating value for shareholders. If that rate of return is below its cost, it is a value-destroying entity.

The rate the entity pays for capital out on loan (bonds and other fixed debt) is almost always below their cost for equity capital. This is because fixed rate debt is typically backed up by a security interest in its assets, it is given preference in the event of bankruptcy and, the payments it makes to creditors are tax deductible, that is, it does not pay federal income taxes on those profits it pays to creditors in the form of interest.

The calculation of the cost of equity capital is not so easy to determine. To begin, as we have all been witness, the return demanded by shareholders is constantly shifting-minute by minute, second by second-and often quite wildly. But not to estimate cost of equity is to miss half the root by which the fair value of a equity security is determined.

The more profound question and the genesis for cost of equity capital is to evaluate the risk to the free (distributable) cash flows of the firm. An enterprise with perfectly predictable free cash flows would have a low cost of equity capital, since investors could reasonably depend on those flows for their income. Enterprises with unpredictable free cash flows should logically have higher cost of capital as investors may receive sporadic or inconsistent cash returns from the firm.

At CT Capital, we have identified 60+ variables which relate to cash flow and credit which help us identify the risk to the firm’s free cash flows. But this is not how investors in general compute cost of capital, and is, I am convinced, the very reason for the vast financial market volatility we have been going through.

Wall Street analysts, investment strategists, corporate finance departments and their advisor consultants and investment bankers evaluate cost of equity capital based on the swings in the firm’s stock price, known as its beta. There are some other factors thrown in, notably the risk free rate and the market return, but beta is pulling the wagon.

Cost of equity as calculated via the misty lens of stock volatility has been followed by consultants who received their M.B. A.’s at university’s teaching this faulty gospel. These leading management consultants, in turn, have advised Board of Directors these methodologies are the most appropriate approaches, and since they are taught at leading universities, have not been questioned. Because it is forcing investors to evaluate risk incorrectly, it results in large and unnecessarily wide swings, often based on incrementally minor news, whereas the real cost of capital should be based on the long-term ability to generate free cash flows.

All we need to do is think back to May 10th when equity markets rallied about 3% worldwide, only to fall back rather abruptly. Such unnecessary “noise” can be expected to continue unless investors understand how to place a correct cost of capital into their decision-making.

Consider the following:

Fair Value Based on Differing Cost of Equity Capital Assumptions

Fair Value

Current Free Cash flow Per Share

Growth Rate

Discount Rate (Cost of Equity Capital)













The only factor causing fair value to change in the table is the cost of equity capital-current free cash flow and its growth rate remain identical. As evidenced, a one percentage point change, from 8% to 9% in the cost of equity equates to a staggering 25% decline in fair value. If the entity’s risk rises further, to a 12% cost of equity, the stock should be expected to fall by 57%. Such is the importance of the cost of equity (the discount rate), and the reason it must be precisely established to calculate fair value. If an entity’s cost of capital rises, its share price, must, by definition fall, until it reaches its new lower fair value, as shown in the table.

One might ask: If the current free cash flow and growth rate are known, why would fair value differ? It is because the numerator of the present value model is only a guess, even if an educated one, supported by appropriate research and investigation. There are risks to any free cash flow or earnings estimate-patent or customer loss, volatility in input costs, foreign government risk, rollover of debt risk, etc, and these are captured by the cost of equity. The fewer and less serious these risks are, the more certain we can feel about the numerator, the free cash flows. For such an enterprise with above average normalized free cash flow and moderate leverage, lower cost of equity will normally place the entity in a position to add value-adding projects with more facility than its competitors.

Unless investors understand the many cash flow and credit factors which determine cost of equity capital, in favor of basing it on stock price movements, expect investors to not truly understand the reason the equity security should have been purchased in the first place.

Kenneth S. Hackel, C.F.A.

Real Free Cash Flow Not As Strong As Reported

June 4th, 2010

Despite the commonly held belief stocks are selling at preposterously low valuation levels, the same is not true for free cash flows.

When we adjust cash flow from operations to reflect normalized balance sheet activity and working capital items, including the recent spurt in discretionary spending on items such as capex, R&D, SG&A, bonuses, etc, much of this purported free cash in being consumed. For example, Autodesk, which today filed its 10Q, under the most common definition of free cash flow of operating cash flow minus capital spending, showed approx. $132 MM. in free cash flow. Yet, when normalizing working capital, taxes and discretionary items are taken into account, the amount of free cash flow is less than half, at $ 57 MM.

Thus, while we expect press releases to continue to show strong year over year comparisons in net income and even free cash flow, firms, because they do not make the necessary adjustments to cash flow from operating activities, from which free cash flow is based, enterprises will in essence be reporting a misleading number.

The number being reported does not represent cash that could be distributed to shareholders while still allowing for maximum growth.  The CT Capital definition of free cash flow represents the true income for the equity investor resulting from an investment in the enterprise.

For additional information, see “Security Valuation and Risk Analysis.”

Overselling of Risk for Certain High Beta Stocks

June 2nd, 2010

Investors have been selling risk. This is not uncommon during periods of uncertainty, but is rare when the economy is just a year or so out of recession, when earnings and cash flows are expected to rise over the coming years.

When this risk divergence occurs, undervalued and oversold equities often result in large returns compared to other asset classes, as well as stocks in general. Investors, who assign risk based on beta, rather than on fundamental factors, may not be properly calibrating the credit health of the entity.  The list below was assembled with those investors in mind, who believed they were selling (or avoiding) risky assets, when in fact, they were not.

The list was run for entities which are value adding, that is, they have a higher return on invested capital than their cost of capital. After all, that is the primary responsibility of corporate executives. These firms have lower than average leverage, even when including operating leases and pension underfunding. For firms which have seen their operating leases growing by greater than 5% per year over the past 5 years, we assumed such growth would continue, instead of using the GAAP mandated 5-year minimum signed lease obligations. These firms have also been generating positive free and operating cash flows, although over the short-term, even firms in distress tend to produce free cash flows as they take any and all actions to produce maximum cash. Obviously, this can only go on for so long.

Although these firms appear undervalued, they may not be appropriate to all investors, hence strongly urge you do your own due diligence. They would appear, however, as a group, to offer significantly greater value, than the equity market in general.

Risk (Cost of Equity Capital) Rises Again Last Week

May 31st, 2010

The cost of equity capital rose again last week according to Credit Trends comprehensive credit model. While free cash flow multiples are in the bottom half of its 40 year band, risk is in the top half.

Yield spreads, cash tax rate, adjusted operating cash flow and stability metrics rose by the greatest amounts while free cash flow caused a decrease. Additionally, the US 2-10 year Treasury yield curve spread, illustrated below, shows the risk of recession has increased.

Credit Trends reviews 70+ fundamental credit measures in computing its cost of equity capital.

For additional information on the model, you may pre-order “Security Valuation and Risk Analysis.” McGraw-Hill, available at all online book outlets. For the first time, the model will be released to the public.

Expect Continued Stock Volatility

May 28th, 2010

Much of the current stock market volatility is the result of security analyst poor understanding of risk. When security analysts appraise asset values, they discount the expected cash flows. Unfortunately, the rate they use is based on a measure of volatility (the beta) and not on fundamental measures, such as cash flow and credit strength. Because the cost of capital (this discount rate) has such as strong effect on fair value, it is resulting in unprecedented price swings.

Investors Need To Better Understand Risk

If it seems like200+ point swings in the Dow Industrials are a daily occurrence, it’s because it is. Over the past three months, in fact, the Dow has fluctuated in a 15% trading range and the S&P in a 16.5% range. The financial press, following the lead of investment strategists, has laid blame for these large price movements alternately on euro weakness, possible new legislation here in the U.S, trading restrictions in Germany, and various events in Greece, China, Turkey, Spain, and elsewhere. When blame is placed on alternating events, stock volatility is normally a result of other factors. The real culprit, I am certain, is investors, in general, do not have a proper understanding of security risk. That being the case, fear often engulfs analytical judgment as investors become unsure how to properly measure the expected returns along various asset classes.
When was the last time you heard a securities analyst or investment strategist remark? “Company X had an increase (or decrease) in risk during the quarter,” instead of they beat (or did not) earnings or sales estimates. Risk and reward cannot be solely judged by income statement results.
In truth, companies prosper for one reason: they can generate cash returns above their cost of capital. Simply put, that means the rate of return (measured by the free cash flow) on the assets of the enterprise are in excess of that demanded by creditors and equity holders. The greater and more consistent the margin between cost of capital and the return on invested capital, the safer the investment. Cost of capital, whether it is for equity, debt or hybrid securities are a true measure of risk.
Yet, today, security analysts are taught to gauge cost of capital by a measure of volatility, known as the beta coefficient, which is the security price change related to the change in an index, such as the S&P 500. It is a variable of what they were taught by academicians in business schools, as the capital asset pricing model (CAPM). This popular method of risk assessment is wrong, and is in good part, responsible for the current volatility we are seeing. Cost of capital can only be appropriately measured by the possible impairment to the free cash flows and its relationship to cost of capital. If an investor were certain as to an asset’s free cash flows, the determination of fair value would be considerably easier. But even with absolute certainly, fair value could not be made with perfect precision as economic circumstances change, such as the rate of inflation or tax rates. Those issues aside, a financial analyst should only be concerned with stock volatility if they, or the company they were following, were in the market to buy or sell securities. To the long-term holder, the cost of capital should not be determined by the swings in the stock price. The reliance on stock volatility in the placement of a cost of capital rate is so ingrained in Wall Street (sell-side) analyst research reports that it renders a high percentage of those reports useless. Security analysts are then forced to find an accounting yardstick such as price/earnings or price/book to back up their investment ratings. However, accounting ratios do not often reflect underlying financial risk, cash flows, competitive market position, possible loss of a patent or supplier, financial structure or resources available to the enterprise, which do in fact help determine cost of capital. Accounting concepts are often not a measure of cash that could be used to repay debt or distribute wealth to shareholders.
One never hears of successful builders of businesses mention beta, or other academic statistical risk tools. They talk about products, customers, risk and cash. They talk about growth rates in free cash flow, taxes, and stability. Consider the following, and ask if beta or fundamentals should drive their stock prices:
Georgia Gulf has a beta of just 0.3, indicative of a low risk entity, yet it is rated just “B” by Standard & Poor’s (S&P). A “B” rating by S&P is defined as, among other things, as having greater vulnerability to default than other speculative grade debt that could lead to inadequate capacity or meet timely interest and principal payments.

Comcast is rated BBB (“adverse economic conditions could lead to default”), yet analysts may consider it to have a lower cost of equity capital than 3M, due to its having less stock volatility as reflected by its beta coefficient. A “BBB” rating is regarded by S&P as having predominantly speculative characteristics. 3M is rated AA-, which S&P indicates as having a very strong capacity to repay interest and principal.

Hundreds of companies have low betas, and are thusly accorded a low cost of equity capital- yet they can’t pay their bills! Hundreds of other firms are erroneously accorded a high cost of capital, yet are strong and consistent producers of cash flow and do so with just moderate financial leverage. True, many hundreds of companies are in bankruptcy, technical default or a stiff wind away from that status, yet have a lower cost of capital, because of their stock trading patterns, than say, a Microsoft, or other deserved AAA rated entity.
Cost of equity as calculated via the misty lens of stock volatility has been followed by consultants who received their M.B. A.’s at university’s teaching this faulty gospel. These leading management consultants, in turn, have advised Board of Directors these methodologies are the most appropriate approaches, and since they are taught at leading universities, have not been questioned.
Companies with unpredictable sales, volatile tax rates, upcoming litigation, are not producing positive cash flows, have recently undergone a large business combination, risky foreign exposure, are but a few of the metrics analysts must look at to determine cost of capital, hence risk. Stock swings may not be associated with such factors.
The following table illustrates the difference to cost of equity capital when based on a the credit model employed at CT Capital versus that used by Wall Street analysts basing risk off of the capital asset pricing model. Given a 1% change in the cost of equity can change fair value by a third, it is no wonder stocks are as volatile as they currently are.

Company                    CAPM     Credit Model
Toyota                             7.5%        9.7%
Rite Aid                         6.8%       18.5%
IBM                               10.0%         8.4%

Unless then, investors begin to adopt more suitable risk metrics based on what is important to owners of capital- their ability to earn a cash based return in excess of cost of capital using fundamental metrics, and not stock volatility, the latter often the result of fear, greed, institutional trading or rumor, expect stocks to continue to show aggressive trading swings, the kind that tend to scare most small investors away from the stock market.

News Today

May 28th, 2010

The release from Reuters of a dramatic fall-off in IPO’s and re financings is a negative for cost of capital.

Although deals are being done, the drop effects most companies given the widening of credit spreads. Most net borrowing entities have significantly strengthened their balance sheets over the past year and a quarter, although they are continually dependent on debt and equity markets. Such firms remain especially vulnerable

Risk Needs to be Better Understood

May 25th, 2010

Cost of equity capital has risen for three months in a row, almost on weekly basis. And this week, cost of equity, for the S&P 500 companies, has risen to over 9%, the first time it has crossed this mark in over a year.

What has been the reason for the increase?

According to the CT Capital credit model, and outlined in my upcoming text, “Security Valuation and Risk Analysis,” McGraw-Hill, rise in yield spreads, sovereign risk, cash versus the effective rate, and volatility measures of several fundamental metrics, have led the way.

But they are not the only metrics which pinpoint increases in fundamental security risk.

Most have to do with credit health, such as rollover risk and the ability to repay all debt from a consistent cash flow stream when those cash flows are adjusted to normalized conditions. For example, while cash flow from operating activities and free cash flow have been increasing, when adjusting for normalized levels compared to sales and balance sheet, the rise is subpar, especially when taking into account spending plans.

Most entities which have announced large rises in cash flows plan to have such resources consumed thru additional spending agendas, which are not necessary, given their current sales level. The lessons they have learned from the financial crisis have not sticked. Other enterprises are once again buying back their stock, which, in our opinion, is almost always a waste of corporate assets.

Other credit measures are generally in line with normal conditions, although for certain firms,  cost of capital is indicating a risk to cash flows not currently assumed. Many firms, for example, will see large amounts of cash needed to fund both domestic and foreign benefit plans.

With the multiple on the S&P now suggesting stocks are near fair value ( 2% over-valued), the rise to cost of capital needs to be better understood.

Kenneth S.Hackel, C.F.A

S&P 500 Back To Fair Value

May 21st, 2010

The 3.5% decline in the S&P has now brought the index to approximate fair value, given our expectation of 4% annual growth in free cash flow over the coming five years and a 8.1% cost of equity capital. The last time we wrote this was the case, the S&P rallied 15% over the coming 3 months.

Although the cost of capital has risen over the past month, the decline in valuations, to 17.8x FCF, has resulted in a fair valuation. Although many firms are reporting impressive growth in operating cash flow, we are finding much of this cash is to be consumed in newfound growth initiatives. We would avoid these entities, and would continue to concentrate on firms which have shown continual improvements in their cost structure.

Cost Structure Begins Unnecessary Rise

May 20th, 2010

We have noticed a very broad trend on the part of firms which have, over the past three quarters, shown good growth in free cash flow, especially when associated with moderate top line growth, to begin to pick-up their cost structure.

New growth initiatives, share buy-backs, and increases in SG&A, do not bode well for free cash flow later in the year. If this expected growth does not materialize, the stocks of these companies would give back much of the gains seen over the past year and a half.

Inflation and Cost of Capital

May 17th, 2010

Lower interest rates on the ten-year Treasury (risk-free rate) do not always lead to a lower cost of capital. This was clearly seen during 2008 as interest rates fell yet cost of capital rose, as credits weakened due to the effects of the recession and illiquid credit markets. Conversely, higher rates may not always lead to higher cost of capital, as particular industries benefit from (the fear of) inflation and price increases relative to costs. Where the yield spread and risk-free rate do not capture inflation on the security level,  we adjust cost of capital.
Contrary to popular thinking, a rise in inflation cannot be overcome by a similar rise in revenues-it must be overcome by a similar rise in free cash flows, or cost of capital will increase. Also to be taken into account is the effect of inflation on capital to be replaced. If the cost of such capital has increased at a rate greater than the increase in free cash flows, this metric would result in a greater penalty.
The inflation rate affects economic and business risk, including the value of balance sheet inventory, which may be severely understated for firms using LIFO accounting. And, as history has shown (see Illustration), the impact of inflation is not always accurately divined in the risk free rate, which is used as the beginning building block for the cost of equity capital model. Also, the inflation rate and the expected rate of inflation affect firms differently, and thus this metric may need to be adjusted for those groups. Those enterprises with high leverage, sensitive to commodity price swings, or those enterprises that own significant investments whose values are tied (directly or indirectly) to the level of interest rates, will be more greatly affected by changes in the expected rate of inflation than those entities which can pass along its consequences, such as some utilities.

S&P500 Index

Risk Free Rate

Risk Free Rate

S&P Fair Value and Increase in Risk

May 14th, 2010

We have received a number of emails regarding our perception of the increase in risk overwhelming the rise in free cash flow.

There are many factors which contribute to credit risk, with Sovereign debt and foreign exposure being just two. Please do not forget the rise we are seeing in free cash flow is made possible, in good measure, from cost cutting, to the extent when we adjust for normalized changes in working capital, the increase, while, positive, loses about 40% of its magnitude.

This is not unusual for the initial stage coming out of recession, but must be compared to the very large rise, over the same period, in valuation multiples.

Additionally, our credit metrics, especially our consistency measures, have increased over the past month, while other measures, such as health care, taxes ( not just federal income), and foreign pension burden, have all been rising.

All in all, the S&P is about 5% over-valued. Typically, as stocks can fluctuate wildly around fair value, a 5% over-valuation is within normal range-and can even result in a rally. If that were to occur, we would recommend, as we have been, to sell into such rally.

There are, however, stocks that are as much as 40% undervalued, based on free cash flow growth and valuation, cash based ROIC compared to a credit-based cost of capital, and financial flexibility, and it is there where we continue to focus.

For additional information, contact either myself or Simon Adams

Capital Spending Growth by US Companies to Take Years to See Levels Reached in 2006

May 13th, 2010

Unlike research and development (R&D), which, as we pointed out yesterday, has not seen severe budget cuts, the same cannot be said for capital expenditure budgets.
Although, for all S&P 500 companies, capital spending has rebounded from the Sept 2009 quarter, given lethargic top line and employment growth, we believe any quick snapback in capital spending is unlikely.

As the largest stock returns evolve from a turn of events, not a continuation of one, we are recommending investors (as we have) reduce their exposure to those effected sectors, and overweight sectors with ties to productivity improvements, low cost of capital and high ROIC.

For additional information call Kenneth Hackel, C.F.A. or Simon Adams

R&D Budgets Rebounding

May 12th, 2010

For all S&P reporting companies through May 12, 2010, the median entity has surprisingly maintained its R&D budget.
For the latest reporting quarter, the median S&P firm spent 4.9% of total sales on R&D, compared to the March 2005 quarter of 4.2%. This is up from March 2009 quarter of 3.9%. Total estimated spending on R&D over this period rose quarterly from $34 bn. to $39.4 bn. These numbers are approximate as not all companies report R&D each quarter, as picked up by S&P Compustat services.

R&D As a Percentage of Sales

The data in the chart is fairly accurate as when we look at annual data for all S&P reporting companies, total R&D expenditures rose from $ 121.4 bn. to $164.7 bn.
CT Capital looks at research spending in relation to revenues, unit growth, cash flows and cost of sales when analyzing free cash flow. A percentage of any overspending in R&D is added to free cash flow. Over the past year, enterprises have, in general, been judicious in their R&P spending as they have in managing their other corporate assets. They continue to be optimistic regarding the potential of their R&D spending.

Reporting firms’ R&D (as opposed to capital spending budgets), have, in general, been maintained within historical standards.

Kenneth Hackel, C.F.A.

Goldman Sachs-Congress Holds the Key to Its Valuation

May 6th, 2010

According to today’s Wall Street Journal, Lloyd Blankfein, Goldman Sachs’ chairman, would like the firm’s clients to know it will be an ethical leader.




Operating Profit









Asset Management & Securities






Investment Banking






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That will, as an inspection of their trading reveals, be quite difficult, unless they do away with their proprietary trading desk. For as long as the firm continues to trade billions of dollars a day for its own account, it will be placing, at times, large bets against its clients.

Unfortunately, its trading desk is too profitable to relinquish voluntarily- at least without a fight. But how does it fight to keep it, given the spate of anti-Goldman sentiment, with its only real beneficiaries being its employees and shareholders? It serves no greater economic or financial good. To the extent the trading desk can manipulate, with its billions of dollars in capital (no figures are released), financial markets in the direction it is betting, its clients’ interests are not just served-they could very well be hurt.

This represents a diametrically opposite picture given by its chairman before the Senate committee last week, in which he gave the impression its trading activities, were incidental to that of its clients. It is apparent that the prop desk represents a very large percentage of its revenues, profits, and cash flow, although it is difficult to precisely determine, especially given the firm’s large interest income, and the extent to which interest results directly or indirectly from the trading desk.

But Goldman will obviously not give up its prop desk unless it is forced to. As the table shows, of its $45.2 bn. in firm revenues, it received 76% from trading; interest income and trading provided 95% of total firm revenue. Of operating profits, 87% came from trading. Included in its trading operations are trading in the most speculative of derivatives, the kind which a slight information edge can result in $1 bn. profit within weeks. Goldman controls over half of the principal program trading on the NYSE. It would be noteworthy to find out the extent to which its short and derivatives portfolio were active bets-not hedges-against clients, and if they solicited such trading so that they could make such active bets. It would be of interest to know how much capital Goldman has, on average, throughout the past years, committed to its prop desk.

One thing is for certain. If Goldman is forced to give up proprietary trading for its own account, or under the careful eye of government regulators must cut back such trading, Goldman Sachs’ franchise value will suffer irreparable harm.

To what extent could we see Goldman Sachs stock drop? To get a clearer picture of the effect of its trading prowess, I looked back 10 years and evaluated the growth in trading had on cash flow and net income. Given Goldman’s last fiscal year $13.4 bn. in net income prior to preferred dividends, I estimate 30% resulted from proprietary trading of its own accounts, or about $4 bn. Given net income of $9 bn., and 526.2 MM shares outstanding, we would still looking at roughly $17 per share, if a cutback were in order. On the other hand, if the firm returns to the wild pre- derivatives era of 2000-2005, when Goldman earned, on average about $6.50 per share, as trading revenue were considerable less than half current levels, but was still very profitable, that absent prop trading, net income could easily be reduced back to the $6.50 per share level. If that were the case, Goldman’s stock would be expected to fall to the $70s, especially given slow economic growth, which would be offset by their high market share given competitor weakness both in the US and Europe.

The most reasonable scenario is some cutback in prop trading, the extent of which cannot be determined or even reasonably estimated. But at its current levels, there appears to be too much risk in the shares of Goldman, despite current strong cash flows and a low valuation multiple. If however, Goldman is able to carry out its business with essentially no change to its prop desk or other businesses, a low probability scenario, I would expect to see a large rally in its shares to the $200 level. For shareholders, the fate of the firm is in the hands of the Congress. And that’s not a risk worth taking.

Apple (AAPL) and its Cash

May 5th, 2010

What do you do when you have $50bn. in loose change in your pockets? This is the dilemma Apple Computer will be facing by the end of its fiscal year. And that may be conservative given Apple’s cash hoard has already risen by $ 10bn. since the end of September.

With its only debt related to lease obligations, Apple has been as big a cash machine as their exists in the US financial marketplace.

Financial theory posits a company that continues to watch its excess cash rise, to the point it is greater than its shareholder’s equity, with no debt other than a reasonable lease structure, would be frowned upon by investors. It is expected such an entity should either return that cash to shareholders in the form of dividends or share buybacks, re-invest back into the business, or to make acquisitions above its weighted average cost of capital.

Apple, however, is an exception to financial theory. They have been so adept at using other firms’ capital, there is really no need, at this time to spend more within, than they are already doing. From their supply chain to their marketing and R&D, Apple is unparalleled.

As Steve Jobs and the board of directors at Apple have so far shown no inclination to pay a dividend or buy back stock, the only remaining outlet for that continuing cash rise is a large acquisition.
And there, the universe is extremely limited, baring a large number of small acquisitions, which Apple can do anyway.

Under a reasonable scenario, Apple management would most likely only approve a large business combination meeting all of the following criteria:

1-Size of Deal- Not greater than $100bn.
2-Target must, like Apple, be conservatively managed, with a strong credit
3-Target must also be strong producer of normalized and prospective free cash flow
4-Target must be in a business Apple understands which can propel their respective competitive positions going forward
5-Target must have return on invested capital at least 3% above its cost of capital

When all these factors are set in motion, only one company stands out: Qualcomm

New Book: Security Valuation and Risk Analysis

April 9th, 2010

Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making

Kenneth S. Hackel, C.F.A.
Reason Book was Written: To introduce a successful and innovative approach to the valuation of equity securities.
Central Tenets:

(a) Cost of capital, a principal component of valuation, should not be determined by stock volatility, as is widely practiced by enterprises, investors, consultants and security analysts, but by the entity’s cash flows and credit health.

(b) Return on Invested Capital (ROIC), a principal component of valuation, should be measured as a function of the assets production of free cash flows, as it should benchmark the expected cash return for cash expended; and

(c) Free cash flow should include cash the entity could easily free up, and this can be captured thru analysis of various discretionary spending areas. EBITDA, an income statement based accounting concept, is not a measure of the true economic return.

Security Valuation and Risk Analysis is a book written to help investors appraise the expected return from an investment in an equity security.

To accomplish the endeavor, half the book is allocated to risk, as measured by cost of capital; half to return, as measured by the investment’s expected cash flows.

Because security analysts are not confronted with the daily barrage of problems and exposures that managers and executives directly working for the entity confront, and rarely are many mentioned during investor presentations, this wide swath of risks tend to be ignored or not properly calibrated. Investors need to think and identify with the chief financial officer to truly appreciate the multitude of exposures the firm faces to accurately determinate a cost of capital that properly takes into account these uncertainties, of which any one could damper cash flows or even threaten the entity’s survival. On the other hand, if investors were to overweight such risks, the entity’s valuation multiple would depress, leading to out-sized investment performance for investors who properly weighed them.

The determination of the proper discount rate is a function of these risk factors, as defined by the cost of equity capital. Only thru an accurate and reliable cost of equity capital can fair value be established, as well as the determination if management is creating value for shareholders, as measured by the free cash flow-based ROIC capital compared to its cost.

The book’s comprehensive credit model replaces and improves upon the Capital Asset Pricing Model, by providing rating criteria of financial health resulting in a superior discount rate which is applied to the firm’s free cash flows. From this, fair value is established.

The text explains why entities having a low ROIC resulting in small amounts of distributable cash flows deserve low valuation metrics despite having higher rates of growth in revenues and/or earnings.
Tax effects are discussed in detail throughout the text as it relates to those affected areas, both from a cash flow effect and its associated financial reporting.

This book explains relevant current accounting requirements and how they are applied by reporting entities, especially to the Statement of Cash Flows. The text is replete with examples to illuminate each topic.
Prominent discussions, analysis and topics relate to:

  • Free Cash Flow
    * How to compute the maximum distributable cash available to equity holders without impairing growth
    * Are cash flows and income telling the same story?
    * The many failings of EBITDA and why it is inappropriate for use by practitioners and business analysts, including its use as a measure of unlevered cash flow
    * Adjustment procedures for normalizing reported cash flow from operating activities to both improve comparability and eliminate management influence.
    * The adjustment of various other expenses which could free cash, such as cost of sales, SG&A, and capital spending.
    * The analysis of taxes, including cash rate stability and cash versus effective rates.
    * Shows how improved balance sheet management has the same impact as an increase in revenues or free cash flow
    * Analysis of cash flow volatility
  • Cost of Capital
    * Why a 1 percentage point change in the cost of capital often results in a 25% change to fair value
    * Why analysts often ignore the Capital Asset Pricing Model
    * A discussion of the prominent cost of capital models and how IBM could not accurately estimate its cost of capital using them
    * Importance of yield spreads to the cost of capital
    * Sensitivity analysis for components of cost of capital
  • Return on Invested Capital
    * How it should be defined using free cash flow (not EBITDA, net income or operating cash flow) and a realistic capital base
    * Why it is management’s chief responsibility to continue to improve the firm’s ROIC and reduce cost of capital.
    * Why share buybacks only rarely add value and do not improve ROIC
    * How a new large capital investment would be analyzed and discussed from the point of view of the firm.
    * How economic profit, using free cash flow, should be implemented, when ROIC is not appropriate.
  • Financial Structure
    * A thorough analysis of the roles debt, equity and hybrid securities play in the capital structure including possible calls on capital such as commitments, contingencies, guarantees, convertible securities, exposure to lawsuits and other cash requirements, such as sinking funds. Also explored are contingent capital, debt covenants, adjusted debt, goodwill, special purpose entities, contingent liabilities, and the importance of sensitivity analysis in evaluating financial structure.
    * Detailed explanation, with examples of the accounting for pension and other post-retirement benefits, including healthcare. Importance of studying non-US plans, whose liabilities are often growing much more quickly than a firm’s US plans.
    * Detailed explanation with examples, of derivatives and hedges, used for risk reduction as well as a speculation.
    * Thorough explanation of lease accounting, including why current accounting rules almost always result in an understated liability. Clarification of tax accounting and reporting under the Statement of Cash Flows.
    * Analysis of the roles played by of credit rating agencies, including how they evaluate ratings as well as their importance and influence

Underperformance of High Capital Intensive Firms

April 7th, 2010

Capital intensive firms have had a rough time of it the past five years. Not only has business slowed, but lots of property, plant and equipment (PPE) means lots of debt, not all of which appears on the balance sheet. Nevertheless, debt, like operating leases and that associated with special purpose entities, represents legal obligations that demand repayment.

The chart below shows the five-year performance of firms which have gross PPE at least three times that of their positive shareholders equity, assets of at least $500 million, and a market value of at least $250 million.


While the chart shows these firms have had, as expected, negative relative performance, there is now reason to believe, based on CT Capital’s cash flow/cost of capital models, many of the set are primed to recover ground, the extent of which is dependent on their upcoming ability to generate growing free cash flows.  Others, especially, when off-balance sheet debt is included, appear to offer little in the way of potential return to equity holders.

As with all bull market runs, investors look for laggards, and especially investment managers who make a habit of accepting high risk hoping to show strong catch-up investment performance.

The catchword is to be very careful with this group; yet quite a few names appear to offer excellent relative value.

However, if the industries in which these companies operate do not grow as expected, their operating and financial leverage could result in financial failure or extreme loss of market value.

For information on the study please email and look for “Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making” later this fall from McGraw-Hill.

Kenneth S. Hackel, C.F.A.

Healthcare Legislation to Severely Impact Cash Flows and Valuation

March 25th, 2010

From Caterpillar’s 8K released today:

As a result of the Patient Protection and Affordable Care Act (H.R. 3590) signed into law on March 23, 2010 (the “Act”), beginning in 2011 the tax deduction available to Caterpillar Inc. (“Caterpillar”) will be reduced to the extent its drug expenses are reimbursed under the Medicare Part D retiree drug subsidy (RDS) program. Although this tax increase does not take effect until 2011, Caterpillar is required to recognize the full accounting impact in its financial statements in the period in which the Act is signed. As retiree healthcare liabilities and related tax impacts are already reflected in Caterpillar’s financial statements, the change will result in a charge to Caterpillar’s earnings in the first quarter of 2010 of approximately $100 million after tax. This charge reflects the anticipated increase in taxes that will occur as a result of the Act. As mentioned on page A-106 of Caterpillar’s Form 10-K for the year ended December 31, 2009, Caterpillar’s 2010 Profit Outlook is based on tax law in effect as of February 19, 2010 and does not include the impact of the Act.

The recently approved healthcare legislation will have a material impact on cash flows not currently reflected in stock prices. Companies like Caterpillar, P&G, 3M, and IBM, which have a high ratio of retired and near retired, to an active workforce, will be most affected by the rise in cash taxes. But almost all firms will be impacted.

We have reviewed our model portfolio, and believe other investors will be doing the same. The result will be an increase to cost of capital which will reduce valuation multiples.

As firms have been able to show large reductions to pension plan liabilities, resulting from the large rally in stocks during 2009, with commensurate improvement to shareholder’s equity, the healthcare law will refocus investors to the benefits area. If the 2009 valuation benefit is not repeated, the cost to S&P 500 companies will be in the many billions of dollars.

And if the reduction in valuation multiples causes stocks to falter, as we expect, the health care legislation will turn out to be a very costly.

Next-Credit Ratings Are Still Important In Determining Stock Valuation

October 1st, 2000

During the height of the credit crises a short 2 years ago, the hint of a credit downgrade was sure to result in an outsized drop in the underlying stock. Now, with balance sheet re-liquefaction and built-up capital, the fear of a credit rating is not near as worrisome.



Coming Next-Is IBM Losing Its Competitive Edge?

September 16th, 2000

In this article we look at evidence that strongly suggests that IBM, despite being turned into a cash “machine,” has done so not through its own R&D efforts but rather through massive cost cutting.

Would Sam Palmisano fire Sam Palmisano?

Coming Later This Week

August 16th, 2000

Is the selling in HPQ overdone?

It appears that HPQ offers investors good value- but is there anything brewing beneath the surface?

If you had a copy of that book to the right, you would know.

A Better Indicator Than Net Income

August 9th, 2000

Over the past 10 years, this variable has had a remarkable correlation to with future stock prices- and it’s not net income.