{"id":545,"date":"2010-07-08T19:04:20","date_gmt":"2010-07-08T23:04:20","guid":{"rendered":"http:\/\/www.credittrends.com\/blog\/?p=545"},"modified":"2010-07-08T19:05:05","modified_gmt":"2010-07-08T23:05:05","slug":"cash-flows-productivity-and-stock-prices","status":"publish","type":"post","link":"https:\/\/www.credittrends.com\/blog\/2010\/07\/08\/cash-flows-productivity-and-stock-prices\/","title":{"rendered":"Cash Flows, Productivity and Stock Prices"},"content":{"rendered":"

<\/a>Most corporate managers and economists believe productivity measures lie at the top of determinants of value creation and corporate health. \u00a0For that reason, it is a recurring theme during meetings with investors and in regulatory filings, as expressed in a September, 2009 8-K filing for Kraft Foods (KFT) concurrent with their bid for Cadbury PLC:\u00a0<\/p>\n

\u201cA strong pipeline of cost-savings initiatives will result in higher productivity and better margins as part of its three-year plan.\u201d<\/p>\n

We will see that while productivity is certainly an important factor which could lead to higher cash flows, its positive bearings are primarily confined as a measure of consequence to the current or soon-to-be free cash flow producer. \u00a0For, if a firm\u2019s products are met with insufficient demand, and the inputs under which they are produced do not generate satisfactory cash flows, it would be rare for productivity improvements to be able to turn the business around. \u00a0If the entity is a satisfactory producer of free cash flow, then productivity improvements can indeed lead to even greater free cash flow and a higher security price. \u00a0For this reason, top line growth and cash flow from operations are more important valuation and cost of capital metrics, than productivity.\u00a0 In fact, productivity measures are an over-rated metric.<\/strong><\/p>\n

During periods of slow growth, or expectations of slowing growth, managers often pursue a downsizing strategy, including layoffs, efficiencies, and reduction in the number of manufacturing facilities, all in an effort to improve long-term productivity. But what can realistically be expected from such actions?<\/p>\n

Corporate executives who are continually reviewing their internal portfolio, enhancing their products and lines of business, filling in strategic gaps where necessary to improve core competencies, while eliminating and streamlining those assets that underperform, with an eye on cash flows, typically see higher returns on invested capital than those entities which simply look to shed labor as a quick fix solution.<\/p>\n

This is an important distinguishing factor in CT Capital\u2019s cost of capital credit model. \u00a0While the model considers productivity boosting measures as value enhancing, it is not awarded the large weighting most investors\u00a0 believe exists, and for companies which are not positive producers of cash flows, its weighting is zero. \u00a0The weaker the cash flows, the lower the importance of enhancing productivity is to cost of capital improvement.\u00a0 If an entity has no prospect of ever generating free cash flow, its equity value, as a going concern, is at best zero, regardless of how many units it produces.<\/p>\n

The workforce and productive capital and plant can be set once current and projected operating and free cash flow are reasonably estimated; it would be imprudent to match workforce and plant with units of production or revenues if the entity is not capable of generating long-term free cash flow.<\/p>\n

Determining the optimum labor force as being a function of sales or unit output does not reflect upon an enterprise as a cash flow maximizing entity but rather as a unit producing entity.\u00a0 Determining output based on profits may not leave distributable cash to the owner of equity. The corporate managers and analyst must therefore determine the level of output that places free cash flow at its highest \u00a0level , both today and prospectively.<\/p>\n

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Free cash flow is maximized at that point on the chart where labor is most efficient.\u00a0 If the current level of employment cannot produce satisfactory free cash flow, management must seek a lower cost labor pool, downsize the labor force, become more productive, raise prices, reduce other expenses, or lastly, sell the asset. If, by virtue of such action(s), the entity turns into a free cash flow producer, it has value to its equity owners.<\/p>\n

For a detailed analysis of stock prices, cash flow and productivity, see “Security Valuation and Risk Analysis<\/a>“, McGraw Hill, November, 2010.<\/p>\n

Disclosure: No positions<\/p>\n

Kenneth S. Hackel, C.F.A.
\nPresident
\nCT Capital LLC<\/p>\n

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Most corporate managers and economists believe productivity measures lie at the top of determinants of value creation and corporate health. \u00a0For that reason, it is a recurring theme during meetings with investors and in regulatory filings, as expressed in a September, 2009 8-K filing for Kraft Foods (KFT) concurrent with their bid for Cadbury PLC:\u00a0 […]<\/p>\n

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