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Methodology Summary:

  • Profitability based on free cash flow rather than reported earnings
  • Both current situation and trend are considered, but the emphasis in this research is on trend
  • Both book value of common equity and estimate of intrinsic value are considered in financial strength, but the emphasis in this research is on intrinsic value
  • Quality Of Free Cash Flow: growth in debt, capital expenditures, inventory, receivables and payables in relation to the growth of free cash flow. Only companies with a competitive advantage and at least mediocre management are able to grow free cash flow faster than capital expenditures and debt, and free cash flow faster than growth in inventory, receivables and payables.
  • no emphasis on EBITDA because, as Buffett and Seth Klarman have pointed out, EBITDA assumes that depreciation and amortization are not real expenses. They are. Visit here for more.

Primary elements in our risk/reward analysis:

(1) RISK

Financial Strength And Trends (50% weighting of risk total score):
  • Ratios of debt to equity, interest coverage by free cash flow, current situation, trailing twelve months versus prior twelve and five year trend
  • Equity and free cash flow versus long term debt and total liabilities. Equity is considered two ways: book value and intrinsic value (see below).
  • Liquidity: cash, receivables, relative to current liabilities, long term debt, total liabilities and total assets. Inventory and receivables relative to sales.
Financial Strength Trend Including Profitability (10% weighting of risk total score):
  • Largest single factor: Return on equity by free cash flow. Free cash flow is based on trailing twelve months less average capital expenditures over the last five years.
  • Trends in margins (gross profit, operating profit, net profit) also factors, although those are also reflected in free cash flow/equity.
  • Trends in capital turnover (revenue/assets) factors, although again these are also implicit in free cash flow/equity.
  • Growth in earnings, book value per share, margins, capital turnover, dividends with a primary emphasis on growth in free cash flow. 
Quality of Earnings (10% weighting in risk):
  • Quality of earnings assesses the ability of the business to grow without growing debt, capital expenditures, inventory, receivables, S,G&A in relation to book value. 
  • Payables rising faster than free cash flow results in a demerit.
  • Stability of earnings: the ratio of years where free cash flow improved over the prior year versus the number of years where it declined. Five and fifteen years considered.
  • Dividend growth covered well by free cash flow results in a higher Quality of Earnings Score on the theory that boards of directors are reluctant to increase dividends during periods when the businesses' trends are uncertain or adverse.
Quality of management (10% weighting in risk)
  • five year average return on equity. Forty percent weighting. Over 25% ROE by free cash flow gets top rating, under 5% gets zero score.
  • financial strength. Debt levels in relation to equity and free cash flow and interest, liquidity, current situation, trailing twelve month trend versus prior twelve months, five year trend. Thirty percent weighting.
  • stability of free cash flow over the last five years. Fifteen percent weighting.
  • growth (free cash flow, revenues, gross profit, operating income, net income, EPS, book value per share) trailing twelve month and five year. Emphasis on free cash flow growth. Fifteen percent weighting.
Quality of Board Of Directors (10% weighting in risk)
  • Background of board, 40% weighting. Successful entrepreneurs gets the highest score, senior executives of successful companies next highest, consultants next, academics next, family members, friends, hacks and toadies lowest.
  • CEO salary as a percent of gross profit compared to similar-sized companies. 20% weighting.
  • Insider Ownership. 20% weighting. Fifty percent or more gets a top score, five percent or less a zero score.
Quality of management (see criteria above) gets a 20% weighting.
  •  Quality Of Business (10% weighting in risk):
  • Quality of management (see above). 25% weighting.
  • Return on equity: five year average (20% weighting). Over 25% ROE by free cash flow gets top rating, under 5% gets zero score.
  • Quality of earnings 15% weighting. See above.
  • Financial statement trends, 15% weighting. See above.
  • Stability of free cash flow. See above.
  • Quality of earnings, 15% weighting. See above.
  • Growth of free cash flow, revenues, gross profit, operating profit, etc. (See above) 10% weighting
  • Similar factors to Risk, but with reduced emphasis on financial strength (30% as opposed to 50%)
  • Undervalued or overvalued receives a 20% weighting. For instance, a company selling at 50% or less of our estimate of intrinsic value gets a score of 20 out of 20. A company selling at a premium of 20% or more of our estimate of intrinsic value gets a zero, but may do so well in other categories (profitability, quality of earnings, growth) that its overall score is still superior. 
  • Intrinsic value is estimated primarily on free cash flow per share, and trend in free cash flow growth. A company with growth of over 10% per year is valued on the average ratio of stock price to free cash flow over the last five years, the Graham and Dodd growth formula, PEG ratio and the average price to book value over the last five years. Cyclical companies with volatile, unpredictable earnings are valued on (low and average) price to book value over the last fifteen years. Average dividend yield is also considered. Companies with no growth are valued at a 6% discount rate, or a multiple of about 16.7, book value relationship and dividend yield. As interest rates rise, that multiple will be reduced. 
  • For bonds, rather than undervalued or overvalued, the yield to maturity is used. So a bond yielding over 20% would get a score of twenty out of twenty, a bond yielding 5% to maturity (based on ask price) would receive a score of 5 out of 20.


Over the last thirty years, I've developed credit analysis tools that identify financial statement trends, and then compare values and trends with hundreds of other companies. This research evolved out of work I did in the early and mid-1980s for corporate acquirers and special situation investors including Leucadia, Sam Zell, Jay Jordan, Richard Rainwater and an Australian company, Industrial Equity. The focus of my research was out-of-favor and distressed securities, including the bonds of companies in default.

Most of my work in those days consisted of investigative research. I would interview former senior executives, former directors, customers, competitors, etc. and sit in bars outside factories and talk to workers when they came off shift. What used to be fun  airports and hotels  became a little old.

In 1988, Buffett invested over $1 billion in Coca Cola at fifteen times earnings, twelve times cash flow, and five times book value. I had always thought of him as a value investor, and the stock seemed to me to be overpriced. When the position proved to be highly-profitable, I studied it and realized that the company was undergoing significant fundamental positive change. Its margins and capital turnover trends were benefiting from the liquidation of mediocre operations and expansion into global markets.

In those days, I had a two-to-one, losers-to-winners, ratio. Fortunately, the winners made a lot more than the losers lost. Thinking about that Buffett position, I seemed obvious that had I employed the financial statement trend analysis techniques that Buffett was apparently employing, I could have avoided almost all of the major losers in my own portfolio and the losing investments I had recommended to clients. Financial statement analysis, done carefully and exhaustively, could have allowed me to focus my time and travel where it could generate the best returns.

I spent the next six months developing an Excel-based financial statement analysis model. I had to use an OCR scanner to accumulate historical data from 10Ks, 10Qs etc. on microfiche. I worked on that problem day and night for several months, but ultimately gave up. During the bear market of 2009, after running a successful company for fifteen years, I began this work anew, and have over the last ten years developed analytical tools in Excel and Python, condensing the number crunching that took me a couple of months to complete as recently as September 2016 into a couple of hours. This software helps me identify emerging and established trends in:

  • growth

  • profitability

  • leverage

  • liquidity

  • quality of earnings 

  • price in relation to free cash flow, book value

Reported earnings are secondary to free cash flow in this analysis. The definition of free cash flow varies from analyst to analyst. The definition I use:

  • 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. That is usually a good thing, a positive contributor to investment performance. There are exceptions however, for instance

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 back tests underlying this research:

  • Moody's Credit Analysis Metrics.
  • 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.
  • The Altman Z Score

 Although the Novy-Marx and Northern Trust analytical processes were designed to find quality common stocks, the techniques are 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, and, secondarily, operating income
      • free cash flow as a percent of total liabilities
      • long term debt as a percent of assets
      • 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 equity, both book value and estimate of intrinsic value
      • total liabilities as a percent of assets
      • cash plus receivables in relation to current liabilities, total liabilities and total assets
      • accounts payable in relation to revenues
      • CEO salary in relation to gross profit versus companies with similar levels of gross profit
      • S,G & A in relation to gross profit
      • Book value per share growth
      • dividend growth

    Eighty percent weight in this analysis is given to trailing twelve month versus prior twelve months, ten percent to five year trends and ten percent to latest quarter versus prior year quarter. In effect, this gives 30% emphasis to latest quarter.

    How sensitive management is to shareholders is also an important element in this research:

    • 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

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