Someone who reads my blog sent me an email saying he thought capital intensive industries usually have low profit margins.
Here’s what I said…
Actually, high profit margins are pretty common in capital intensive businesses.
Here's one way of thinking about it:
Profit / Sales = Profit Margin
Sales / Assets = Asset Turnover
Profit Margin * Asset Turnover = Return on Assets
So, a capital intensive railroad might have a 10% profit margin but only a 0.40 asset turnover ratio. That means only a 4% return on assets (10% * 0.40 = 4%). By contrast, a grocery store might have a 2% profit margin but a 3.00 asset turnover ratio. That means a 6% return on assets (2% * 3 = 6%).
So, a grocery store can be a better business than a railroad if the store turns its assets fast enough to make up for the low profit margin...Also, free cash flow / net income is usually higher at a grocery store than a railroad. See my article on depreciation at railroads for details on why railroads free cash flow is always so much lower than their reported earnings.
This is basically what’s called a DuPont analysis. It’s just a certain way of writing out the drivers of return on investment. It’s a framework. Something the management inside DuPont used about 90 years ago.
It’s taught in schools. So a lot of people recognize it when I mention profit margins and asset turnover. But a classic DuPont analysis is not the whole story for investors.
For investors…
The value of an investment is based on the cash that can be withdrawn from it over time. So an investment's "right" price to tangible book value ratio should be determined by its free cash return on tangible assets times its acceptable leverage ratio. A world class grocery store will have a higher free cash return on tangible assets than a world class railroad even though it will certainly have a lower profit margin. That's because good grocery stores both turn their assets faster and convert their earnings into cash better than railroads who plow a lot of these alleged earnings back into maintenance capital spending. However, a railroad could still have a higher return on equity if it used more leverage than a grocery store.
The table below gives the 10-year averages for each variables at a railroad, Union Pacific (UNP, Financial), and a grocery store, Village Supermarket (VLGEA, Financial).
Personally, if I had to choose between paying book value for Union Pacific or paying book value for Village Supermarket, I would buy the grocery store.
But that’s me. Not Warren Buffett.
I’m not saying Warren Buffett is wrong about railroads. I’m saying he bought railroad stocks – and then eventually the entire Burlington Northern – based on improvements he saw in the business. Warren Buffett saw the variables – margins, asset turns, etc. – getting better.
And that’s a perfectly good reason to buy a stock or to buy a business. Your return in an investment isn’t going to be based on past results. It’s going to be based on future results. That means it’s the future profit margin, asset turnover, leverage ratio, and cash conversion rate that matter.
Not the past.
For me, I don’t have strong views one way or the other on how the future of railroads will differ from their past. So, all I go on is past results. And the past results of most railroads isn’t good enough to justify buying them at today’s prices.
That doesn’t mean you can’t buy railroad stocks. Maybe you should buy them. But you want to buy them based on future estimates of their cash return on equity. And even more so, you want to buy them because you’re convinced they’ll earn a good cash return on your investment in their stock.
How do you calculate that?
Let’s start with the cash return on equity.
To find a stock's cash return on equity, you can use this approach:
Profit / Sales = Profit Margin
Sales / Assets = Asset Turnover
Profit Margin * Asset Turnover = Return on Assets
Assets / Equity = Leverage Ratio
Return on Assets * Leverage Ratio = Return on Equity
Free Cash Flow / Net Income = Cash Conversion
Return on Equity * Cash Conversion = Cash Return on Equity
You can then use the cash return on equity and whatever future compound annual return you expect from the stock market to calculate the “right” price-to-book ratio for a stock to trade at.
For example, let’s say I think the S&P 500 will return 7% a year from now on. Village Supermarket’s cash return on equity is 9.74%, so Village Supermarket’s stock would need to trade at a price-to-book ratio of 1.39 (9.74%/7% = 1.39) to give me the same 7% cash return on my investment that I think the S&P 500 would give me.
And Union Pacific should trade at a price-to-book ratio of 0.69 to give me that same 7% cash return on my investment that I expect from the S&P 500.
Now, I know what you’re thinking…
But, Geoff, that’s crazy. Union Pacific has $35.36 a share in book value. A price-to-book ratio of 0.69 would mean the “right” stock price for Union Pacific is $24.40 a share. But the stock trades at $94.10 a share.
This is madness.
You’re right.
It is.
Investors are pretty keen on railroads right now. Railroads have gotten better over the last 10 years and investors expect them to get even better over the next 10 years.
If you look at the dividend yield on Union Pacific, you can see it’s the future being priced into that $94 stock, not the current return on investment.
Union Pacific only pays $1.52 a share in dividends each year. At a price of $24.40 a share, that would be a 6.23% yield which sounds awfully high in today’s environment. But then look at the actual dividend yield on the stock. It’s 1.62%.
That’s awfully low.
Which is right?
It depends on the future.
Basically, I’m saying the folks buying a railroad like Union Pacific at $94 a share are betting on some improvement in the variables found in that DuPont analysis.
They’re not looking at trailing 10-year averages. They’re betting on better margins, faster asset turns, more financial leverage, better cash conversion, or lower future returns in the stock market. Those are the only things that can justify a $94 stock price.
In a sense, those are really the only variables an investor needs to know.
You should always be able to justify buying a stock using a DuPont analysis.
A lot of people know the basic formula.
But a lot of investors who learn the DuPont analysis in school don’t go in to use it in their everyday investing.
And they don’t take it to its natural conclusion. They don’t look at the cash return on equity the company is getting and the cash return on their own investment they need to get.
In other words, they don’t calculate the price-to-book value ratio they need to buy into the stock at to get the kind of cash return on investment they need to beat the market.
You should always be able to show how and why you expect the cash return on your investment in the company to be higher than the future return on the S&P 500.
That means you need to think about the conversion of reported earnings to distributable free cash flow and the future returns available in other stocks.
If you know all those things, you know the highest price-to-book value you can pay for a stock.
Of course, if you know the stock is better than the alternatives, you don’t actually need to predict future stock market returns. All you need to know is that the stock is a better investment than anything else you can find.
In other words, feel free to drop the future stock returns part of the process if you want to focus on absolute returns instead of relative returns. You can find a stock's expected absolute return by just taking the DuPont analysis and multiplying the return on equity by the free cash flow to net income ratio.
(Return on Equity) * (Free Cash Flow / Net Income) = Cash Return on Equity
Now, for true growth stocks, the cash return on equity isn't as useful as the accrual return on equity, because growth companies are always investing heavily in the future (hopefully at high returns).
You aren't going to value Wal-Mart (WMT, Financial) on its cash return on equity. You're going to use its accrual return on equity. And that's fine, because Wal-Mart is always investing in new stores. And Wal-Mart is always earning a decent return on investment.
I’m not stating that as a fact. I’m saying that’s the other piece of the puzzle you need to have before you can evaluate a growth stock.
But what about a railroad? Is a railroad really a growth stock? Is a grocery store?
Not if almost all if the company’s capital spending and added working capital is being used to support the existing business. A true growth company is something going into new products or new locations. It isn't just paying more money to maintain the same stores and the same rail lines.
So, yes, there are limits to doing a DuPont analysis with the added cash conversion and future stock market return assumptions.
But, especially for folks who are new to the accounting aspects of value investing, I strongly suggest tinkering with a DuPont analysis plus the added assumptions about cash conversion and future stock market returns.
It’s a great way to analyze a stock before buying it.
And it’s a good way to check your assumptions on stocks you already own.
You can’t just say a stock is worth $94 a share. You have to point to something in the formula that’s actually going to get better in a big enough way to justify your purchase price.
And the great thing about this kind of analysis is that it gets you looking at the key variables in the business. You start thinking about stocks you invest in the way Warren Buffett does. You start thinking like a businessman.
And - like Ben Graham says - investing is most intelligent when it is most businesslike.
Follow Geoff at Gannon On Investing
Here’s what I said…
Actually, high profit margins are pretty common in capital intensive businesses.
Here's one way of thinking about it:
Profit / Sales = Profit Margin
Sales / Assets = Asset Turnover
Profit Margin * Asset Turnover = Return on Assets
So, a capital intensive railroad might have a 10% profit margin but only a 0.40 asset turnover ratio. That means only a 4% return on assets (10% * 0.40 = 4%). By contrast, a grocery store might have a 2% profit margin but a 3.00 asset turnover ratio. That means a 6% return on assets (2% * 3 = 6%).
So, a grocery store can be a better business than a railroad if the store turns its assets fast enough to make up for the low profit margin...Also, free cash flow / net income is usually higher at a grocery store than a railroad. See my article on depreciation at railroads for details on why railroads free cash flow is always so much lower than their reported earnings.
This is basically what’s called a DuPont analysis. It’s just a certain way of writing out the drivers of return on investment. It’s a framework. Something the management inside DuPont used about 90 years ago.
It’s taught in schools. So a lot of people recognize it when I mention profit margins and asset turnover. But a classic DuPont analysis is not the whole story for investors.
For investors…
The value of an investment is based on the cash that can be withdrawn from it over time. So an investment's "right" price to tangible book value ratio should be determined by its free cash return on tangible assets times its acceptable leverage ratio. A world class grocery store will have a higher free cash return on tangible assets than a world class railroad even though it will certainly have a lower profit margin. That's because good grocery stores both turn their assets faster and convert their earnings into cash better than railroads who plow a lot of these alleged earnings back into maintenance capital spending. However, a railroad could still have a higher return on equity if it used more leverage than a grocery store.
The table below gives the 10-year averages for each variables at a railroad, Union Pacific (UNP, Financial), and a grocery store, Village Supermarket (VLGEA, Financial).
| Profit Margin | Asset Turnover | Return on Assets | Leverage Ratio | Return On Equity | FCF / Net Income | Cash ROE | |
| UNP | 10.03% | 0.39 | 3.91% | 2.78 | 10.87% | 0.44 | 4.82% |
| VLGEA | 1.66% | 4.06 | 6.74% | 1.70 | 11.46% | 0.85 | 9.74% |
But that’s me. Not Warren Buffett.
I’m not saying Warren Buffett is wrong about railroads. I’m saying he bought railroad stocks – and then eventually the entire Burlington Northern – based on improvements he saw in the business. Warren Buffett saw the variables – margins, asset turns, etc. – getting better.
And that’s a perfectly good reason to buy a stock or to buy a business. Your return in an investment isn’t going to be based on past results. It’s going to be based on future results. That means it’s the future profit margin, asset turnover, leverage ratio, and cash conversion rate that matter.
Not the past.
For me, I don’t have strong views one way or the other on how the future of railroads will differ from their past. So, all I go on is past results. And the past results of most railroads isn’t good enough to justify buying them at today’s prices.
That doesn’t mean you can’t buy railroad stocks. Maybe you should buy them. But you want to buy them based on future estimates of their cash return on equity. And even more so, you want to buy them because you’re convinced they’ll earn a good cash return on your investment in their stock.
How do you calculate that?
Let’s start with the cash return on equity.
To find a stock's cash return on equity, you can use this approach:
Profit / Sales = Profit Margin
Sales / Assets = Asset Turnover
Profit Margin * Asset Turnover = Return on Assets
Assets / Equity = Leverage Ratio
Return on Assets * Leverage Ratio = Return on Equity
Free Cash Flow / Net Income = Cash Conversion
Return on Equity * Cash Conversion = Cash Return on Equity
You can then use the cash return on equity and whatever future compound annual return you expect from the stock market to calculate the “right” price-to-book ratio for a stock to trade at.
For example, let’s say I think the S&P 500 will return 7% a year from now on. Village Supermarket’s cash return on equity is 9.74%, so Village Supermarket’s stock would need to trade at a price-to-book ratio of 1.39 (9.74%/7% = 1.39) to give me the same 7% cash return on my investment that I think the S&P 500 would give me.
And Union Pacific should trade at a price-to-book ratio of 0.69 to give me that same 7% cash return on my investment that I expect from the S&P 500.
Now, I know what you’re thinking…
But, Geoff, that’s crazy. Union Pacific has $35.36 a share in book value. A price-to-book ratio of 0.69 would mean the “right” stock price for Union Pacific is $24.40 a share. But the stock trades at $94.10 a share.
This is madness.
You’re right.
It is.
Investors are pretty keen on railroads right now. Railroads have gotten better over the last 10 years and investors expect them to get even better over the next 10 years.
If you look at the dividend yield on Union Pacific, you can see it’s the future being priced into that $94 stock, not the current return on investment.
Union Pacific only pays $1.52 a share in dividends each year. At a price of $24.40 a share, that would be a 6.23% yield which sounds awfully high in today’s environment. But then look at the actual dividend yield on the stock. It’s 1.62%.
That’s awfully low.
Which is right?
It depends on the future.
Basically, I’m saying the folks buying a railroad like Union Pacific at $94 a share are betting on some improvement in the variables found in that DuPont analysis.
They’re not looking at trailing 10-year averages. They’re betting on better margins, faster asset turns, more financial leverage, better cash conversion, or lower future returns in the stock market. Those are the only things that can justify a $94 stock price.
In a sense, those are really the only variables an investor needs to know.
You should always be able to justify buying a stock using a DuPont analysis.
A lot of people know the basic formula.
But a lot of investors who learn the DuPont analysis in school don’t go in to use it in their everyday investing.
And they don’t take it to its natural conclusion. They don’t look at the cash return on equity the company is getting and the cash return on their own investment they need to get.
In other words, they don’t calculate the price-to-book value ratio they need to buy into the stock at to get the kind of cash return on investment they need to beat the market.
You should always be able to show how and why you expect the cash return on your investment in the company to be higher than the future return on the S&P 500.
That means you need to think about the conversion of reported earnings to distributable free cash flow and the future returns available in other stocks.
If you know all those things, you know the highest price-to-book value you can pay for a stock.
Of course, if you know the stock is better than the alternatives, you don’t actually need to predict future stock market returns. All you need to know is that the stock is a better investment than anything else you can find.
In other words, feel free to drop the future stock returns part of the process if you want to focus on absolute returns instead of relative returns. You can find a stock's expected absolute return by just taking the DuPont analysis and multiplying the return on equity by the free cash flow to net income ratio.
(Return on Equity) * (Free Cash Flow / Net Income) = Cash Return on Equity
Now, for true growth stocks, the cash return on equity isn't as useful as the accrual return on equity, because growth companies are always investing heavily in the future (hopefully at high returns).
You aren't going to value Wal-Mart (WMT, Financial) on its cash return on equity. You're going to use its accrual return on equity. And that's fine, because Wal-Mart is always investing in new stores. And Wal-Mart is always earning a decent return on investment.
I’m not stating that as a fact. I’m saying that’s the other piece of the puzzle you need to have before you can evaluate a growth stock.
But what about a railroad? Is a railroad really a growth stock? Is a grocery store?
Not if almost all if the company’s capital spending and added working capital is being used to support the existing business. A true growth company is something going into new products or new locations. It isn't just paying more money to maintain the same stores and the same rail lines.
So, yes, there are limits to doing a DuPont analysis with the added cash conversion and future stock market return assumptions.
But, especially for folks who are new to the accounting aspects of value investing, I strongly suggest tinkering with a DuPont analysis plus the added assumptions about cash conversion and future stock market returns.
It’s a great way to analyze a stock before buying it.
And it’s a good way to check your assumptions on stocks you already own.
You can’t just say a stock is worth $94 a share. You have to point to something in the formula that’s actually going to get better in a big enough way to justify your purchase price.
And the great thing about this kind of analysis is that it gets you looking at the key variables in the business. You start thinking about stocks you invest in the way Warren Buffett does. You start thinking like a businessman.
And - like Ben Graham says - investing is most intelligent when it is most businesslike.
Follow Geoff at Gannon On Investing
