Financial Reference

The following is my response to an article by James Stewart in SmartMoney encouraging an investestment in Burlington Northern. The article can be found at: SmartMoney

Your analysis of Burlington Northern is lacking. While I would hate to be on the other side of trade as Buffett, I believe he has found a good company selling at a good price. This is not a great company selling at a good price or a good company selling at a great price.

More importantly, throwing out a P/E, ROE, and growth rate is only the start of the analysis. The problem is that these figures are misleading when it comes to many companies, including Burlington Northern.

Earnings are unimportant if they do not reflect the underlying cash flows. Just ask any investor in Enron. While Burlington’s earnings are real (unlike Enron) they have significant capital expenditures that offset their earnings and make the underlying valuation much more expensive. The earnings of $1.9B should be offset by the difference between maintenance capital expenditures and D&A ($1.5B - $1.1B) or $400M. The free cash flow generated by the business was therefore approximately $1.5B in 2006. The company’s Price/Cash Flow is equal to 31.6/1.5 = 21.

In addition, your use of ROE is misleading because it is an accounting construction rather than a real financial measurement. What matters is the return on the capital the company invests. By the company’s own admission, they have increased this number from the single digits to a record 11.4%. Not an impressive return on capital and much lower than the accounting construct you quote.

While I believe that Buffet has found a good company with good management, the valuation is not compelling. An investor is paying 21 times cash flow for a company that returns 11% in a banner year. Unless the future is unusually bright for the company — a company with high fixed costs and a unionized workforce — there are more compelling investments to be found.

Of course, I’m talking about growth…because I’m a finance geek. Somehow growth has become the all-important factor in determining the attractiveness of a stock.

Case in point: according to Fortune (April 2, 2007; p. 114), the top 100 US stocks by market cap are selling at 14 times earnings, the companies that rank from 501-1000 in capitalization sell at 21 times earnings, and the companies that rank from 1,001-3,000 sell at 28 times earnings.

It’s the anti-nifty 50. Large, safe companies are selling at historically low prices while small, risky companies are selling at huge premiums. Why? The sexy little g.

At some point this will change and we’ll start hearing about the relative safety of larger companies. The funny thing is: nothing will have changed. The basic valuation equation never changes, even though different parts of the equation are emphasized from time to time.

The basic valuation (constant growth) model is:

(Cash Flow next year)/(Discount Factor - Growth)

Since the Discount Factor is a function of risk, the value of the firm is determined by both the safety and the growth. Today, every other article is about the growth prospects of a stock. Over time, this will change and we will be inundated with articles stressing the safety of an investment.

I have a suspicion that those seduced by the sexy little g today will be waking up with regrets the morning after.