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April 11th, 2011 by hackel No comments »

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Interview with the CFA

March 22nd, 2011 by hackel No comments »

Last month I sat down with David Larrabee, CFA,  of the CFA Institute to discuss how investors and analysts should define and measure free cash flow, cost of capital and return on invested capital.

It may be seen at

Protected: Stock Based Compensation-An Important Metric in Fundamental Cash Flow Analysis

March 22nd, 2011 by hackel No comments »

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A Comprehensive Understanding of Individual Security Risk

March 15th, 2011 by hackel No comments »

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Japan and Country Risk

March 14th, 2011 by hackel No comments »


While I have written on the subject of sovereign or country risk before, the tragic earthquake in Japan again forces us to revisit the topic.

One source in our analysis is the US State Department website. They write:

“Japan is faced with the ever-present danger of deadly earthquakes and typhoons.  Japan is one of the most seismically active locations in the world; minor tremors are felt regularly throughout the islands.  While responsibility for caring for disaster victims, including foreigners, rests with the Japanese authorities, one of the first things you should do upon arriving in Japan is to learn about earthquake and disaster preparedness from hotel or local government officials.”

Prior to the disaster, at CT Capital, we had marked-up all Japanese based firms by 35 basis points over Canada, and 10 basis points over the U.S. This mark-up is now 90 basis points over Canada and 65 basis points over the U.S. The additional mark-up reflects the stepped-up exposure to disasters and the current impact on of the disaster on the general economy. There is also some exposure to terrorism in Japan, but not at a level greater than the U.S.


Country Risk-Summary

Companies that are subject to certain jurisdictions may be riskier (political, currency, taxes) for investors than U.S. – based companies.  This was acutely reflected during the fiscal crises in Greece during 2010, with almost immediate repercussions throughout Europe, Asia and the United States. The resultant weakness in the euro impacted US entities with operations in Europe or sold into that market with the US dollar based goods. On the other hand, the price of oil dropped since its price is quoted in dollars.  During the period the crisis was at its peak, many entities which had planned to enter the debt markets to raise capital were not able to do so.

The conditions under which a company operates and has major facilities or markets will thus influence cash flows, consistency measures and leverage. As we have seen, energy exploration companies have had their operations nationalized, while many companies have been harmed by high inflation outside the United States. If an entity receives a significant portion of its cash flows from a non-US geography, the risk to those cash flows must be assessed, with a mark up to cost of capital, where appropriate. This is especially true for companies operating in emerging markets, where a mark-up to cost of capital is always made, even if the cash flows from those areas are currently strong and without incident.

All possible threats and the entity’s sensitivity to any related factors must be considered, including sanctions, tariffs, threat of retaliation of US Government actions, stability of currency, exchange control, inflation, threat of its neighboring countries, restrictions, etc.

At CT Capital, we evaluate 19 factors in our cost of equity capital model, including, in addition to the above, form of government, natural disasters, energy dependence, corruption and commitment to markets and business.


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


Ford-Good Engineering-of the Financial Kind

March 4th, 2011 by hackel No comments »

The decision by Ford to eliminate its tax liability valuation reserve represents financial engineering in its truest sense. While, according to Bloomberg, the act will add $10 billion to $13 billion in net income this year, it has no impact on free cash flows.

Given the volatility in the automotive sector, there is little assurance that Ford will remain a tax paying entity, given it has received refunds (a negative tax rate) in four of the past 10 years.

Consistent tax rate companies at any level normally also have cash flows that are more predictable- Ford, it cannot be argued has been a historically consistent generator of free cash flows.


Owing to losses occurring during 2008, many entities were forced to establish or increase their valuation reserves based on their historical taxable income and projected future taxable income, including the expected timing of the reversals of existing temporary differences. If the entities operated at a loss for an extended period of time, were unable to generate sufficient future taxable income, or if there was a material change in the effective tax rates or time period within which the underlying temporary differences become taxable or deductible, these entities could be required to record a valuation allowance against all or a significant portion of their deferred tax assets, which could increase their effective tax rate for such a period substantially. This could affect cash flows for those firms that used a simple definition of cash flow as net profit plus depreciation.


Obviously, Ford management wished to avoid a continuation of this scenario.


Kenneth S. Hackel, CFA


Risk Rising Modestly

February 22nd, 2011 by hackel No comments »


Changes in risk-real or perceived-has been at the crux of every major economic and financial dislocation. Most recently, the fall in prices of financial instruments leading up to the 2008 worldwide credit crisis and subsequent 2009 price recovery began with a whiff of credit depression and later, relaxation.

Even for periods between crisis and recession, political and self-inducing events can place valuations and prices under strain, forcing an upward revaluation of cost of capital.  As such, equity investors must continuously monitor change in the financial markets risk profile. If the perception of risk is increasing, even if cash flows and credit health are currently strong, one should expect the prices of financial instruments to decline.

This risk to cash flows is incorporated and is the purpose of the cost of equity capital.

Current political tensions have slightly elevated the risk to free cash flows, causing us to raise our cost of equity capital by 15 basis points for all U.S.-based companies. From China to the Mid-East, the re-valuation of risk metrics in our models is apparent; however, an over-reaction to events  is also not justified given the factors we look at. We do not carry direct investments in the most effected countries.

Included in the factors we assess when assigning a cost of capital score for the sovereign risk metric include terrorism, inflation history, fear of nationalization, hunger, poverty, and corruption. Needless to say, most of these metrics pointed to the negative outcome we are witnessing today.

The groundswell that began in Egypt is empowering citizens around the globe, and while it has not spread to the most industrialized nations, it would be naive to assume, given large budget deficits in U.S. States and Federal government, there could not be some backlash here as well. Pensions and rising costs (education, food, and clothing) could spur scattered protests and widespread news coverage.

At present such risks are contained, but one which could impact both the current level of consumer confidence as well as capital decisions. And while a 15 basis point increase will not result in a shift to our current portfolio, it does serve to ratchet up the required return for making equity investments.

Inflation is also a weighty factor in the cost of capital, entering into both the risk free rate as well as other metrics.

It is difficult to find a reporting firm that has not been negatively impacted by the rise in input costs, with warnings of a continuing negative impact to come. In China, some companies are reporting wages are rising as much as 40% for factory workers. We currently assess a cost of capital for Chinese companies 75 basis points greater than Canadian companies given similar free cash flows and credit health. US firms receive a 25 basis point mark-up over Canadian firms.

Here in the U.S., yields are rising due to commodity cost pressure and, according to Federal Reserve data, lower foreign purchases of U.S. bonds. Hedge funds are also increasing their leverage, according to Federal Reserve data which tracks borrowing against bonds not tied to the US Government, as these funds attempt to leverage up.

While our credit models continue to indicate improvements to free cash flow, we are not seeing a strengthening in credit for the S&P Industrials over the past 2 quarters, which we can tie directly to the outlays for share repurchases.

All in all, we cannot be so blind as to ignore recent happenings, as is captured by our various model metrics, including credit spreads and political tensions. We see that yields on third world debt and credit default swaps have been rising as well, while the latter remain steady for U.S. fixed income instruments, perhaps a result of Federal Reserve policy and hedge fund buying.

With cost of capital having slightly risen, one would expect investors to pay closer attention to cash flow and credit. This has not generally been the case over the past year and a half, as evidenced by the tightness of junk bond yield spreads.

Kenneth S. Hackel, CFA

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February 11th, 2011 by hackel No comments »

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For An Accurate Presentation of Free Cash Flow, Correct Classification of Statement Items Required

February 7th, 2011 by hackel No comments »

A review of EDGAR filings, the SEC system for which public companies transmit financial information, finds over 90% of reporting companies defining free cash flow as operating cash flow minus capital expendituresExample:

MORRIS TOWNSHIP, N.J., January 28, 2011– Honeywell (NYSE: HON) today announced full-year 2010 sales increased 8% to $33.4 billion vs. $30.9 billion in 2009. Earnings per share (proforma) were up 12% to $3.00 versus $2.69 in the prior year, excluding the unfavorable impact of the pension mark-to-market adjustment. Reported earnings per share for 2010 were $2.59 versus $2.05 in the prior year. Free cash flow (cash flow from operations less capital expenditures) was a record $3.6 billion (cash flow from operations of $4.2 billion).

Source: Honeywell 8K

Unfortunately, corporate financial reporting does not often provide investors with an accurate assessment of the real free cash flows, and hence adjustments to reported financial statements are required. Free cash flow should be defined as the maximum amount of cash an entity could distribute to shareholders without impairing its rate of growth or through return of capital.

Hence, it is up to the analyst to reclassify those financing and investing activities which are more appropriately operating activities and, as such, would provide (potential) investors with a more realistic indication of the true free cash flow generating capacity of the enterprise. This is true even though classification of a particular activity is prescribed or generally accepted, as we see in the examples below.


For “payments to noncontrolling interests”, to whom as long as they continue to operate profitable operations may be due cash, payments are classified as financing activities while the purchase of the noncontrolling interests would be classified as an investing activity. Unfortunately, for investors who fail to reclassify the payments to the operating activity section, under the common definition of free cash flow, the reader of the financial statement is left with the impression of exaggerated, and incorrect, free cash flows.

For instance, AmSurg Corporation (AMSG), in partnership with physicians, operates surgery centers, where the partnerships may result in cash payments due the minority owners. Such operating cash payments which may result from profitable locations are as much a cost of doing business as payment of salaries or taxes. In common practice, the company classifies these outflows as Financing Activities, the payments representing “outflows or other distributions to owners”, as set forth under FAS 95.

Under the microscope of free cash flow, where free cash represents the income to shareholders of the common stock, the analyst would need to deduct such outflows, which in AmSurg’s case, is sizeable, accounting for over half of reported Cash Flow from Operating Activities (see below). To do otherwise would seriously misrepresent free cash flows as these payments could not be given to shareholders without impairing capital.

To conclude that AmSurg had free cash flows of $214 MM (we add sale of PPE in the Statement shown) would be incorrect. The analyst would need to reclassify the $130.9 MM as an operating activity from which capital spending and proceeds from PPE would be factored, leaving free cash flow as $83.1 MM, or 37% less than would normally be defined.

At CT Capital, as explained in Security Valuation and Risk Analysis, we also account for overspending in discretionary areas, so that, in the case of AmSurg, we would add $2.7 MM back to free cash flow to account for overspending in its cost of goods sold, which could represent overspending of many items in the production and sales process. We would also deduct half of the share repurchases, or $6.3MM, which represents that amount of cash necessary to maintain a steady share count over the prior year. Share based compensation has a real cost. The other half of the buyback would in fact represent free cash flow. Thus free cash flow for the year would approximate $79.5MM, which would depict the maximum distributable cash available for shareholder distribution, or free cash flow.

When making adjustments to published financial statements, the analyst must also adjust or normalcy of one-time (extraordinary) payments or events. Also, taxes, interest and dividends a firm would classify as an investing or financing activity should most often be melded into operating activities. This will also allow for better comparability.

AmSurg Corp.
Consolidated Statements of Cash Flows
Years Ended December 31, 2009, 2008 and 2007
(In thousands

2009 2008 2007
Cash flows from operating activities:
Net earnings $ 181,350 $ 165,926 $ 150,303
Adjustments to reconcile net earnings to net cash provided by operating activities:
Depreciation and amortization 22,927 20,815 18,648
Net loss on sale and impairment of long-lived assets 455 922 724
Share-based compensation 4,068 4,710 4,560
Excess tax benefit from share-based compensation (32 ) (1,351 ) (3,322 )
Deferred income taxes 14,703 14,729 8,063
Increase (decrease) in cash and cash equivalents, net of effects of acquisitions and dispositions, due to changes in:
Accounts receivable, net 1,494 3,792 (2,300 )
Supplies inventory (60 ) (83 ) 47
Prepaid and other current assets (733 ) 2,344 (2,958 )
Accounts payable 1,289 (1,904 ) 962
Accrued expenses and other liabilities 6,666 (487 ) 8,128
Other, net 457 283 61
Net cash flows provided by operating activities 232,584 209,696 182,916
Cash flows from investing activities:
Acquisition of interests in surgery centers and related transactions (95,826 ) (118,671 ) (162,777 )
Acquisition of property and equipment (19,930 ) (18,379 ) (24,640 )
Proceeds from sale of interests in surgery centers 1,298 3,812 5,433
Repayment of notes receivable 1,666 1,458 2,616
Net cash flows used in investing activities (112,792 ) (131,780 ) (179,368 )
Cash flows from financing activities:
Proceeds from long-term borrowings 137,178 157,787 178,316
Repayment on long-term borrowings (116,951 ) (114,788 ) (89,712 )
Distributions to noncontrolling interests (130,855 ) (118,769 ) (103,545 )
Proceeds from issuance of common stock upon exercise of stock options 201 9,970 17,661
Repurchase of common stock (12,587 ) (12,413 )
Capital contributions and ownership transactions by noncontrolling interests 1,036 582 480
Excess tax benefit from share-based compensation 32 1,351 3,322
Financing cost incurred (17 ) (41 ) (200 )
Net cash flows (used in) provided by financing activities (121,963 ) (76,321 ) 6,322
Net (decrease) increase in cash and cash equivalents (2,171 ) 1,595 9,870
Cash and cash equivalents, beginning of year 31,548 29,953 20,083

Exhibit 2

In the Statement of Cash Flows for Boeing (BA), we would reclassify both the “Payments to noncontrolling interests” and the “payments on guarantees” to the operating activity section, thereby reducing free cash flows. Payments on guarantees represent the impact and success of the firm’s operations, including its ability and technical skills in the manufacturing process as well as their ability to provide services promised, and should therefore be considered operating, not financial or investing activities. Payment on guarantees would be considered a reversal of profits, which is an operating activity under the indirect method.

The Boeing Company and Subsidiaries

Consolidated Statements of Cash Flows

(Dollars in millions)
Years ended December 31, 2009 2008 2007
Cash flows – operating activities:
Net earnings $ 1,312 $ 2,672 $ 4,074
Adjustments to reconcile net earnings to net cash provided by operating activities:
Non-cash items –
Share-based plans expense 238 209 287
Depreciation 1,459 1,325 1,334
Amortization of other acquired intangibles 207 166 152
Amortization of debt discount/premium and issuance costs 12 11 (1 )
Investment/asset impairment charges, net 151 50 51
Customer financing valuation provision 45 84 (60 )
(Gain)/loss on disposal of discontinued operations 36 (28 ) (25 )
(Gain)/loss on dispositions, net 24 (4 ) (38 )
Other charges and credits, net 214 116 197
Excess tax benefits from share-based payment arrangements (5 ) (100 ) (144 )
Changes in assets and liabilities –
Accounts receivable (391 ) 564 (392 )
Inventories, net of advances and progress billings (1,525 ) (6,168 ) (1,577 )
Accounts payable 1,141 318 (198 )
Other accrued liabilities 1,327 554 1,126
Advances and billings in excess of related costs (680 ) (1,120 ) 2,369
Income taxes receivable, payable and deferred 607 744 1,290
Other long-term liabilities (12 ) (211 ) 71
Pension and other postretirement plans 1,140 14 (143 )
Customer financing, net 104 432 1,458
Other 199 (29 ) (247 )
Net cash provided/(used) by operating activities 5,603 (401 ) 9,584
Cash flows – investing activities:
Property, plant and equipment additions (1,186 ) (1,674 ) (1,731 )
Property, plant and equipment reductions 27 34 59
Acquisitions, net of cash acquired (639 ) (964 ) (75 )
Contributions to investments (2,629 ) (6,673 ) (5,710 )
Proceeds from investments 1,041 11,343 3,817
Payments on Sea Launch guarantees (448 )
Reimbursement of Sea Launch guarantee payments 40
Purchase of distribution rights (178 ) (182 )
Net cash (used)/provided by investing activities (3,794 ) 1,888 (3,822 )
Cash flows – financing activities:
New borrowings 5,961 13 40
Debt repayments (551 ) (738 ) (1,406 )
Payments to noncontrolling interests (40 )
Repayments of distribution rights financing (357 )
Stock options exercised, other 10 44 209
Excess tax benefits from share-based payment arrangements 5 100 144
Employee taxes on certain share-based payment arrangements (21 ) (135 )
Common shares repurchased (50 ) (2,937 ) (2,775 )
Dividends paid (1,220 ) (1,192 ) (1,096 )
Net cash provided/(used) by financing activities 4,094 (5,202 ) (4,884 )
Effect of exchange rate changes on cash and cash equivalents 44 (59 ) 46
Net increase/(decrease) in cash and cash equivalents 5,947 (3,774 ) 924
Cash and cash equivalents at beginning of year 3,268 7,042 6,11

Additional disclosure: CT Capital is long AMSG for client portfolios

Mergers, Importance of Factoring Stock Based Compensation, and Are Analysts Too Top Line Oriented?

January 28th, 2011 by hackel No comments »

Capital deploying investments typically have a negative effect on their current period’s cash flows. If viewed as projects which safely add to ROIC above cost of capital, such investments can be expected to benefit shareholders, even if the short-term cash flows are impaired. As firms ramp up production or go through the common but expensive integration costs, investors should not lose sight of longer term benefits. Unfortunately, this is often not the case, and so, for investors who can spot and take advantage of the market’s skepticism, superior returns await.

» Read more: Mergers, Importance of Factoring Stock Based Compensation, and Are Analysts Too Top Line Oriented?

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January 13th, 2011 by hackel No comments »

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The Importance of Cost of Equity in Security Valuation

January 10th, 2011 by hackel No comments »

(The following article appeared on CNBC’s Guest Blog on Friday, January 7th, 2011.)

If you really want to know what will happen to stock prices, look no further than the cost of equity, also known as the discount rate.

Put simply, this arcane-sounding metric is a stock investor’s return requirement for making a particular investment. The more the risk, the higher the expected return.

But the real question is: How should investors measure risk?

Academics believe it should generally be tied to the risk-free rate like the 10-year Treasury yield plus a mark-up for the volatility of the stock.

They’re wrong, and here’s why it is important:

A change in perceived risk significantly alters a firm’s fair value, even when current free cash flow and growth rate remain unchanged.

For example, a one percentage point rise in a company’s cost of equity to 9% from 8% equals a one percentage point rise in risk. That one percentage point rise in risk, in turn, translates into a staggering 25% decline in fair value. If the company’s risk rises further – to, say, a 12% cost of equity — the fair value should be expected to fall by 57%.

That’s why the cost of capital is so important. If a company’s cost of capital rises, its share price, must, by definition, fall until it reaches its new lower fair value, as shown in the following table.

In general, risk is measured by the uncertainty of the firm’s future free cash flows. Free cash flows are, in essence, the income to the investor; they represent the maximum amount of cash the firm could distribute without impairing its growth.

Sure, analysts use other measures to arrive at fair value, including market value of the individual parts, liquidation value, price/sales, price/earnings, or price/book. Book value has proven to be an unreliable metric if the book consists of assets where buyers at fair market prices are absent. What is the value of an asset for which there are either no buyers or buyers at unreasonably low prices?

It is the free cash flows, which must then be discounted. But at what rate?

In order to arrive at a fair value estimate for an equity security, an analyst or investor must discount the firm’s free cash flow by a rate equal to the perceived risk. And the risk is a reflection of the uncertainly of the free cash flows. Treasuries will be discounted at the risk free rate plus a small mark-up for the loss of its investment grade status. The amount of the markup is up to the analyst.

That’s why estimates of free cash flow and earnings are called estimates! And because they’re estimates, they’re at the whim of such risks as the loss of patents or customers, volatility in input costs, litigation, inadequate insurance (e.g., BP (BP) was self-insured), foreign government-related issues and rollover of debt, whatever. These risks must be captured by the cost of equity. The fewer and less serious these risks are, the more certain we can feel about 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.

The ability to assess risk to the free cash flows through the adjustment of the cost of equity (discount rate) will provide you with a tool which will place you head and tails over just about every securities analyst you see on CNBC or elsewhere. I can also assure you that over the coming years you will be hearing and reading a lot about the appropriate setting of the cost of capital.

So where do things stand now?

According CT Capital LLC’s comprehensive credit model, and, as outlined in my text, “Security Valuation and Risk Analysis,” (McGraw-Hill), the fall in yield spreads, sovereign risk, improvement in credit strength, and rise in free cash flows, have reduced the cost of equity capital to 7.9% for the S&P Industrials from 8.3% a year earlier. Thus, one should expect a 7.9% return for the S&P over the next year, based on the current level of risk.

So, next time your hear during a company presentation or read in an analyst’s report a cash flow estimate, make sure you understand all of the potential risks to the forecast, made possible through a thorough reading of all SEC filings, for in so doing, your expected return will not only shift, but be more realistic.

Kenneth S. Hackel is president of CT Capital LLC, an institutional investment advisory firm. An internationally recognized expert in security analysis, he has managed the nation’s leading mutual fund, a large investment advisory firm, and has consulted and written on mergers and acquisitions and fairness opinions. He is the author of the leading textbook on cash flow based security analysis,“Security Valuation and Risk Analysis.” To read more visit his blog, You can contact Ken here or request additional information on institutional US Equity advisor, CT Capital, here.

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Slowing Economic Growth Means Greater Focus on Economic Profit

December 31st, 2010 by hackel No comments »

As I have long pointed out, firms which can add to their capital base projects that are value adding (have a return on invested capital (ROIC) greater than cost of capital, with a good margin of safety), will reward shareholders. But what happens when firms cut back their own such spending or have the ability to piggyback others’ capital or resources, such as R&D or support functions?

As the current period of slow economic growth continues, firms may continue to ration their capital base, seeking creative means toward higher free cash flows. Included will be using “others” capital as well as the time-honored low cost producing outlets.

Companies can, especially as the trend to low-cost manufacturing countries evolves, be expected to continue to reduce their property, plant and equipment (PPE) relative to revenues, with a resultant increase in balance sheet cash, short-term investments, and expansion opportunities. Certainly, Apple Computer (AAPL) has been a leading company in this regard, and in the process has been generating very high amounts of excess cash. Investors are, in Apple’s case, ignoring the very low returns on its cash in their valuation of the company, focusing instead on its high economic profit.

As industrial efficiencies evolve, improvements in technology take place, and management consultants develop techniques to enhance supply and production methods, productivity improves and the growth rate of productive capital falls. This need for less capital intensity positively affects return on invested capital, cash required and financial ratios.  McKinsey & Co. found the median level of invested capital for U.S. industrial entities dropped from around 50% of revenues in the early 1970s to just above 30% in 2004.[1]

What McKinsey found in 2005 has only picked up momentum since. Worldwide competition for sales and market share, especially as economic growth has slowed, has led to additional expense skimming and creative means to reduce or minimize the capital base given a projected revenue stream.

For certain industries, which have a naturally low capital base, such as service-oriented entities, return on invested capital will be naturally high. And for manufacturing entities which effectively utilize outsourcing or other entity’s capital for a substantial part of assembly or service, they too, would have an unnaturally low capital base resulting in high ROIC. That does not make return on invested capital any less important; however, we introduce another measure, which is intended to evaluate the cash return on the company’s deployment of resources—its economic profit. The economic profit should then be compared to sales. Doing so can remove many of the distortions of ROIC and improve inter-company comparability.  Even when ROIC makes sense, economic profit should be employed as another measure to evaluate the firm.

Economic profit could also be related to other firm factors, such as total employees or units sold. Doing so would provide the analyst with comparability measures specific to a particular industry or situation. When used in this way, economic profit can indicate management ability to create value relative to its peer group or the direction and efficiency of its spending. For example, a pharmaceutical company analyst may wish to look at the economic profit per researcher.

Economic profit is defined as a company’s free cash flow exclusive of interest income minus a capital charge, with the charge calculated as the company’s weighted average cost of capital multiplied by the operating invested capital. The traditional definition of economic profit utilizes after-tax operating profits in lieu of free cash flow.


Calculating the 2008 Economic Profit for 3M (MMM) using the following financials:

From the free cash flow, interest income is subtracted since we are computing the economic return on the invested capital, not the total free cash flows, which include the returns on the financial assets as well.

MMM’s economic profit was $ 2.2 bn. during 2008

When we compare MMM’s economic profit to its 2008 revenues of $ 25,269 mil, we arrive at 8.9%, which could then be compared to its historic results or to other companies in its industry.  The economic profit could also be related to employee headcount or other useful factors important to the company.


This is how Clorox (CLX) computed its economic profit for fiscal years 2007-2009. As seen, it utilized a partial cash flow format by excluding some non-cash charges.

Source: Clorox Corp 2009 10K

Clorox could have taken its definition a step further, as we did with MMM, by substituting free cash flow for operating profit, since operating profits are subject to GAAP and we are gauging cash return, to compare the result to revenues or other useful measures, including invested capital.  We believe our definition of free cash flow and capital employed to be more reflective of invested capital than is Clorox’s definition. Clorox uses a weighted average cost of capital (WACC) of 9% but doesn’t reveal how that was determined. It is most likely they are using the Capital Asset Pricing Model (CAPM) to compute the equity cost of capital.

I have found that firms that focus on economic profits as well as ROIC, have a greater tendency to engage in value creating opportunities. The beneficial effect of higher free cash flows results in superior stock performance for their shareholders. The trend toward using other entity’s capital is not confined to the manufacturing sector, as service entities also deploying labor outside of their cost structure.

Related articles:

Disclosure: No positions

Kenneth S. Hackel, CFA
CT Capital LLC

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If you are interested in learning more about cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.

[1] McKinsey & Co. study based on an analysis of more than 600 companies with sales of more than $ 100 mil. “Comparing Performance when Invested Capital is Low,” 2005, McKinsey Quarterly.

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Password Changed

December 22nd, 2010 by hackel No comments »

Sorry, but I didn’t realize anyone could go to Amazon and search the book for the clue to the password.

Please send us proof of purchase—the invoice from Amazon-and we will immediately provide the updated password.

About Credit Trends (a division of Investment Essentials, LLC)

December 21st, 2010 by hackel No comments »

Credit Trends is a division of Investment Essentials LLC.


Credit Trends and Investment Essentials were established to manage equity portfolios based upon1- Free Cash Flow-the maximum amount of cash an entity could distribute to shareholders from operations, includes an analysis of discretionary expenditures, both over- and under spending as well as those liabilities which should have been reflected on the primary financial statements. It also includes classification errors in the statement of cash flows

2-Return on Invested Capital-presents us with a real cash on cash return management has been able to earn on invested capital. It begins with our proprietary definition of free cash flow, not operating earnings

3-Cost of Capital-our models capture the true operating and financial risk of the entity and form the important discount rate from which fair value is derived. It captures everything from sales, input  and tax stability to litigation, yield spreads and sovereign risk. It is a true measure of the risk to prospective free cash flows.

CT Capital’s proprietary definition of cost of capital was developed using sophisticated modeling and analytic techniques supported by a decade of research. Its models consist of over 70 factors which result in a superior discounting mechanism from which to discount an entity’s free cash flows.
CT Capital’s free cash flows result from converting to a quasi-cash accounting thru eliminating many of the accounting conventions companies utilize which can help create an “artificial” result. We also add to this result by incorporating enhancements such as evaluating unnecessary and exaggerated discretionary areas which could be used to enhance free cash flows.
To learn more, please contact us:

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For Some Investors, Time to Rock the Boat

December 20th, 2010 by hackel No comments »

“don’t rock the boat, don’t tip the boat over
rock the boat, don’t rock the boat baby
rock the boat-t-t-t-t”

– Hues Corporation

The current bull market in equities, taking the S&P 500 from a fall of 10% to a rise of 14%, is making many investors complacent when, perhaps, they should be acting. Investor analysis and action has greater implications if interest rates and cost of capital rise, which would be common at this stage of the economic cycle. Firms which have a large spread between their cost of capital and return on invested capital (ROIC) will have a critical advantage over those firms which have more narrow spreads, which will ultimately lead to earnings and cash flow disappointments for the latter group. To the extent the bull market has made these firms overvalued, their stocks should be sold.

» Read more: For Some Investors, Time to Rock the Boat

Firms Holding On To Cost Cuts

December 17th, 2010 by hackel No comments »

The bull run in stocks with increasing consumer confidence would ordinarily lead to a partial reversal of the significant cost cutting which has been more than partially responsible for the large increase in free cash flows. Typically found is reduction in overhead both during and several quarters out of recession, at which point costs once again flair up.  According to McKinsey & Co., only 10 percent of cost reduction programs sustain their results three years on.

» Read more: Firms Holding On To Cost Cuts

Will the New Year’s Rally be Reversed with a Low Score in the Super Bowl?

December 14th, 2010 by hackel No comments »

Investors are a superstitious bunch, and with superstitions or inkblots, many see patterns that are figments of the imagination. January effect, summer rally (or doldrums), Super Bowl effect (low scores associated with poor stock markets), Yom Kipper rally, Santa Clause rally, or perhaps even an October massacre, may be in the cards for 2011.

» Read more: Will the New Year’s Rally be Reversed with a Low Score in the Super Bowl?

Protected Posts Open to……..

December 13th, 2010 by hackel No comments »

Anyone who purchases a copy of the acclaimed text, Security Valuation and Risk Analysis

Protected: Apple Inc. (AAPL) – CT Capital’s Fair Value Estimate

December 13th, 2010 by hackel No comments »

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How Dividends Can Destroy Value

December 13th, 2010 by hackel No comments »

News from the Federal Reserve last week that balance sheet cash represents 7.4% ($1.9 trillion) of non-financial corporation’s assets presents as much reason for fear as celebration. In fact, the CT Capital credit model may actually penalize firms having excess cash due to: (1) fear it will be unwisely spent; and, (2) balance sheet cash lowering the return on invested capital (ROIC). I much prefer firms invest excess cash into additional opportunities which offer even greater prospective free cash flows (adjusted for its cost of capital)—that is the very essence of a value-producing entity which brings superior returns to shareholders.

» Read more: How Dividends Can Destroy Value