Financial Reference

It’s so easy to figure out the cheapness of a stock. All you have to do calculate the P/E ratio by dividing the price of the stock by the earnings per share. Right? If only it was that easy…

Even though many well-regarded newspapers mainly limit themselves to the P/E ratio and the projected growth rate.

Many stories read like this, “HP trades at a forward P/E multiple in line with IBM and several points cheaper than Dell. This is a bargain of a growth technology company with the Price-Earnings-Growth ratio now under 1.”

In other words, all you have to do is compare P/E ratios — either current or forward (projected one year forward) — and you can figure out what is cheaper.

The problem with the raw P/E ratio is that it is overly simplistic. For example, the $14 billion in cash on Dell’s balance sheet is not accounted for in the ratio. If we account for the cash on the balance sheet, by taking out the interest income from income and the cash from the market cap, the adjusted P/E will show a much more accurate picture.

While this calculation is only the beginning of the analysis, it is an easy adjustment to make and can make a huge difference in the analysis.

(Disclosure: I own Dell but do not own any of the other securities mentioned)

I received some “research” in the mail the other day about a company called Tubearoo (Ticker: TUBR.PK). Apparently, they are going to be the next MySpace or YouTube and get bought out for hundreds of millions or perhaps even billions of dollars. I’ld hate to be the one who missed out on that. Especially after they sent me glossy research telling me it was going to happen.

There are some major differences between TUBR and the other companies that make a buyout unlikely. In fact, I question whether the company can continue as a going concern.

In the ten years since the company was founded, it has been able to recognize $960 in revenue. Each quarter the company is losing $40,000. They have less than $200,000 in cash and have $300,000 in debt coming due next February. Somehow the price of the stock reflects a market value of around $140 million.

I doubt a company with such a history of non-performance will be able to refinance it’s debt. If they can’t refinance, they will be forced to sell equity if they can; unless operations improve substantially, they may be forced into bankruptcy.

In the meantime, a shareholder will continue to send out research so he can, presumably, drive demand for the supply he is releasing into the market. Every few months he releases more “research” into the market. Please don’t fall prey to such marketing efforts.

I just wish I could short the stock. Since the stock trades as an over-the-counter stock, we can not short it. If we were allowed to short stocks built up by the puffery of interested parties, less people would be sending out “research” like this and fewer people would be trapped by such false claims. Not allowing investors to weigh in and vote in these circumstances is anti-capitalistic and encourages misleading claims. Hopefully one day we will help to bring down such shady operators.

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.

How would you describe your investment style? The first way people usually describe their style is value vs. growth. But what does this distinction really mean?

Growth investors, as the name implies, invest in companies with great growth prospects that usually sell at a premium to the market P/E or P/B (Price/Earnings and Price/Book). They invest in companies like: Nextel, UnitedHealth Group, Tyco, AES, InterActiveCorp, Amazon.com, J.P. Morgan Chase, Google, and Aetna. (Disclosure: I own shares of AES as of this writing.)

Value investors, on the other hand, traditionally invest in companies with low P/E and P/B. They invest in companies with lesser growth prospects that sell at a lower price relative to current cash flows.

However, these distinctions are not as clear cut as people would have you think. For example, the companies mentioned above as growth companies are the top nine holdings in Legg Mason Value Trust –– arguably the most successful value fund in history. Is the fund mislabeled? Or are the labels “value” and “growth” misleading? I argue that that latter is correct.

The descriptions “value” and “growth” are overused and confusing. P/E, P/B, and Div yield are of little use in defining real value. Value is the present value of future cash flows, and as such, growth is an intrical part of the value equation. (Mathematically speaking, assuming constant growth, Value = CF/(discount rate-growth). So the higher the growth rate, the higher the value of the security.)

“Most analysts feel that they must choose between two approaches customarily thought to be in opposition: ‘value’ and ‘growth.’ Indeed, many investment professionals see any mixing of the two as a form of intellectual cross-dressing. We view that as fuzzy thinking…Growth is always a component in the calculation of value, constituting a variables whose importance can range from negligible to enormous and whose impact can be negative as well as positive.” (Warren Buffett, Berkshire Hathaway annual report, 1992)

Despite the constant conversation otherwise, value and growth are not opposites, but are very positively correlated. Intelligent “value” investors see the value in growth. And intelligent “growth” investors see the value in a reasonable valuation. So the next time someone asks whether you are a value a growth investor, you can do what I do, and give them a very confused look and stumble through a lengthy explanation.