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To elaborate on the summary provided under Home on this website, this research is based on the following additional techniques and investment considerations:

Free Cash Flow Versus Reported Earnings

Reported earnings are secondary to free cash flow in this analysis. The definition of free cash flow varies analyst to analyst. The definition that is the basis of this research:

  • two year average net income plus depreciation minus five year average capital expenditures
  • no adjustment to free cash flow is made for fluctuations in inventory, receivables or payables, or deferred taxes, but major consideration is given to quality of earnings. The primary elements of quality of earnings: growth in capital expenditures, debt, receivables, inventory and payables relative to growth in free cash flow.

Like all research approaches, there are both advantages an disadvantages to favoring free cash flow over earnings. Companies with rapidly growing earnings, but with capital expenditures that are growing even faster, are penalized under this approach. That is usually a good thing, a positive for investment performance. There are exceptions however, most notably

Free cash flow is closest to earnings actually available to owners to fund growth, dividends and stock re-purchases. Although roughly three-quarters of the emphasis of this research is on free cash flow, growth in book value and in reported earnings are also considered. 

. . . . .

See the following studies for more on the academic papers and backtests underlying this research:

  • Graham and Dodd's Security Analysis.
  • Research by Joseph D. Piotroski (developer of the Piotroski Score), professor at The University of Chicago Graduate School of Business here.
  • Research on improvements to the Piotroski F-Score here.
  • A study by Robert Novy-Marx, professor of Business Administration at the Simon Graduate School of Business at the University of Rochester, New York, here
  • Northern Trust's Quality Company Scoring System here.

 Although the latter two were designed to find quality common stocks, the techniques are very useful in analyzing debt.

Competitive Position Analysis

    Michael Porter, a professor at Harvard, and author of several books, including Competitive Advantage, is perhaps the most widely-recognized expert in understanding and documenting the characteristics that determine competitive advantage. The key characteristics are, he says:

    • the overall profitability of a particular industry or sector
    • an individual company's competitive position within that industry as determined by its ability to deliver to the customer something truly unique in the way of value or quality
    • both of these factors are largely determined by five sub-factors:
      • Competitive rivalry. 
      • Bargaining power of suppliers. 
      • Bargaining power of customers. 
      • Threat of new entrants. 
      • Switching Costs. Threat of substitute products or services. 

    A crucial consideration in assessing competitive advantage: how vulnerable to change is a particular company. Highly-profitable companies such as Microsoft and Apple are, for instance, susceptible to changing technology. Wrigley's and Coca-Cola are significantly less so. 


    I use several approaches to value, and then compare the average and median values indicated by the different approaches:

    • value indicated by free cash flow (average two year earnings plus depreciation minus five-year average capital expenditures) discounted at 6%. Unlike the other approaches to value that I follow, this approach gives no premium for growth.
    • value indicated by the average of the median and low five-year (for non-cyclical companies, fifteen-year for cyclical companies) P/FCF ratio and price to free cash flow ratio over the last five, ten and fifteen years. This provides an implicit premium for growth as it is valuing based on the subject company's average free cash-flow-to-price ratio, rather than the overall average ratio of the market. 
    • Ben Graham valuation as outlined in the 1962 edition of Security Analysis. This approach suggests P/E ratios that vary by prevalent T-Bill interest rates. In the current (early 2017) rate environment, the indicated P/E ratio ranges from 9.8 times to 48.1 times. For an excellent discussion of this subject see Benjamin Graham And The Power of Growth Stocks by Frederick K. Martin. Instead of P/E ratios, I apply price to free cash low ratios.

     Financial statement trends explored: 

    • Five, Ten and Fifteen Year Free Cash Flow:
      • as a percent of equity (more relevant in banks and insurance companies than return on capital, allowing comparison between financial and non-financial companies)
      • growth relative to growth in debt, capital expenditures, total liabilities, receivables, inventory and payables (quality of earnings analysis)
      • trends in times interest coverage by free cash flow
      • asset growth versus free cash flow growth — measures efficiency, financial stability
      • stability of (variance in) year-to-year free cash flow. All companies have variance  they are not, after all, machines but rather human enterprises that grow and shrink in a resistant environment  but one measure of quality is a degree of stability relative to other highly-profitable companies. On the other hand, a superior company in a highly-cyclical industry can have an exceptional long term average return on equity, but experience wide year-to-year variance based on industry cycles. Schlumberger was an example, although gradually, over the years, its return on capital has steadily declined, indicating that it may no longer be a particularly high-quality company.
    • Trends in capital turnover and margins, the constituent components of return on assets 
    • Debt as a percent of fixed capital
    • CEO salary in relation to gross profit versus peers
    • S,G & A in relation to gross profit
    • Book value per share growth
    • growth in book value per share and dividend

    Fifty percent weight in this analysis if given to trailing twelve month versus prior twelve months, forty percent to five year trends and ten percent to latest quarter versus prior year quarter.

    Emphasis is placed on shareholder-sensitive management:

    • high insider ownership. I place some emphasis on companies with insider ownership of 25% or more.
    • reasonable CEO compensation relative to other companies with similar gross profit and insider transactions. I chart CEO compensation (including stock options) in relation to companies with similar levels of gross profit. I track this relationship in hundreds of companies.
    • insider transactions. While even the highest quality companies tend to experience more selling than buying, I consider the combination of generous stock option grants, heavy selling and minimal insider ownership a significant negative

    The Grizly Bond Trader outlines both the positives and negatives to the extent I am aware of them, including facts that don't support my conclusion. 

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