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Robert Abbott
Robert Abbott
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Book of Value: How Well Is Management Using Its Equity, Debt and Assets?

3 ratios provide most of the information we need, but not without also checking cash flows

March 31, 2020 | About:

Continuing his quest to a new investment model, Anurag Sharma explored the criteria for “fundamentally a 'good' business.” As part of that, he continued to try to refute investment cases, or theses, to test their soundness.

In chapter 18 of “Book of Value: The Fine Art of Investing Wisely,” he focused on two areas: capital efficiency and cash flow management. Understanding what’s happening with these two elements will provide a window into a company’s business economics. The information needed comes from the financial statements.

Starting with capital efficiency, the author said just three simple ratios will tell us how well a company is using its resources (equity, debt and existing assets):

  • Return on equity (ROE), which is earnings on shareholder investments. It is a percentage value, calculated by dividing net income by common shareholders' equity.
  • Return on assets (ROA), which is similar to ROE, involves all of a company’s assets rather than just shareholder contributions.
  • Return on capital (ROC), which is based on both shareholder investments and debt. It, too, starts with net income divided by the total capitalization of equity and debt. Return on invested capital (ROIC) is a similar measure.

Sharma wrote, “The three capital efficiency ratios—ROE, ROA, and ROC—together reflect the operating and financial performance of a company. The higher these ratios, the more efficient is the company’s use of the financial resources (equity, debt, and assets) available to it; this is good economics and efficient operations.”

Here are two examples: Walmart (NYSE:WMT) and Target (NYSE:TGT), taken from their GuruFocus summary pages at midday on March 31. First is Walmart, with ROE and ROA in the Profitability Rank column and ROIC in green at the bottom of the Financial Strength column:

GuruFocus Walmart financial strength and profitability

Next, Target:

GuruFocus Target financial strength and profitability

The ROIC figures may be hard to read; they are Walmart 11.04% and Target 15.26%. In this context, they are being compared with their weighted cost of capital (WACC). Both companies are earning more than they are paying for capital, and thus are basically profitable. Overall, we might also say both sets of managers are doing a good job of managing the resources they have at their disposal.

ROE also relates to intrinsic value. The discounted cash flow model uses return on equity, book value, a growth rate and a discount rate. The higher the ROE, the greater the probability intrinsic value will be higher, and so understanding return on equity becomes a must for investors.

Above, Sharma pointed out that the higher the ratios, the more efficiently a company has used its resources. But he does add an important qualification, which is that ratios may be pushed up with the use of debt. He added, “Investors should check that higher capital efficiency is not simply derived through from financial engineering but grounded in well-run operations.”

Further, he argued ROE should not be taken at face value, without finding out what is behind it. That led to a discussion of cash flow and cash flow issues, including its role in disconfirming or refuting an investment case/thesis. He had several specific areas of interest:

  • How the company gets cash to finance its operations.
  • How much cash is being generated.
  • What the company does with this cash.

An examination of cash flow issues usually begins with the income statement; it provides revenues, either in total or broken down by segment. At the bottom of the statement, we find the operating income or earnings. That, in turn, can be worked on a per-share basis to net income per share.

Next, the cash flow statement; here’s an example using Walmart’s most recent annual report (to Jan. 31, 2019):

GuruFocus Walmart cash flow statement January 2019

This image shows cash flows from operating activities; there are also sections on cash flows from investing and financing activities.

After making adjustments for noncash activities, we end up with cash flow from operations (CFFO) or as it’s also known, operating cash flow. Sharma called a “crucial number.” It is the main source of cash, the amount that can be used to not only take care of routine maintenance, but also be invested in new growth opportunities and distributions to shareholders in the form of dividends or share buybacks.

We must remember that Sharma is doing all this analysis with the aim of disproving an investment case and avoiding bad investments. Taking the disapproval or refutation approach is a relatively simple and quick method of testing an investment idea.

Conventional approaches are based on the idea of building a body of evidence in favor of investing. But that might be a never-ending quest, whereas finding just one disqualifying flaw is enough in his model.

After analyzing Walmart’s results for the year ending January 2015, Sharma found he was unable to refute the case for Walmart being a good economic business, based on its capital efficiency. Therefore, it could be a candidate for an investment.

Conclusion

In chapter 18 of “Book of Value: The Fine Art of Investing Wisely,” Sharma showed how he would test a company's economic foundations through analysis of its capital efficiency.

This involved an examination of its return on equity, return on assets and return on capital. All three of these metrics indicate how well management has deployed the cash, debt and assets available.

But the use of debt could mislead the interpretation of return on equity results, so investors were advised to also review cash flow data and issues before making a final judgment about ROE.

Disclaimer: This review is based on “Book of Value: The Fine Art of Investing Wisely” by Anurag Sharma, which was published in 2016 by Columbia Business School Publishing. Unless otherwise noted, all ideas and opinions in this review are those of the author.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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