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Strategies & Market Trends : Gorilla and King Portfolio Candidates

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To: Seeker of Truth who wrote (47774)	10/11/2001 10:56:26 AM
From: Stock Farmer	Read Replies (1) of 54805

Malcolm - why subtract investment in plant, property and equipment (plus IP, knowhow and key technology)? Because you are measuring "economic profit". Which is the difference between what you get from outside the business minus what it actually cost you to generate and service this business. Maybe an example: I spend $5.00 on lemons on Friday. On the weekend my son appropriates some sugar and water and glassware and somehow manages to stop enough people on our quiet little street to capture $6.00 selling lemonade. From which I subtract my $5.00 as a hard lesson in business. He moans that he'll never save enough money for his Nintendo at the rate of $1.00 a week. So I spend $50 and we fill a few weeknights building a spiffy box stand with bright paint and a huge sign that all but pleads "please have pity on a young entrepreneur". The next weekend he does $20 of business on a cost of $12. That's more like it. Now he's figuring on his business yielding up a fancy new game in no time swift. Should I tell him about the cost in property plant and equipment? Or just wash it under the rug? In the real world this cost belongs somewhere. A company that rakes in profit without spending money on PP&E has got to be worth more than one equally profitable but with a higher appetite for capital. There is a technique used to model a business as though every expense is an investment with a particular rate of return. I think it goes by the name "EVA". Instead of attempting to forecast future revenues one assumes that Marketing gives an ROI of x; and R&D an ROI of y, and so on. Then capital in the the business cycle has its own rate of return; there's another for capital held in reserve, and so on. Theory goes one just looks at the spending and extrapolates the returns. I personally think that's much better than the simple "PE" ratio, if one is going to use ratios of things. And it's better for close in work than just extrapolating the ratios in 10-K's forwards. But it's not a good place to start. Neither are comparative ratios like PE unless one has a basis of comparison. IMHO, Focusing on economic profits is the most useful first pass valuation tool around. Kind of like what a T-square and table-saw are for wordworking. Followed closely by a drill press and router. Then maybe band saw and jointer and jig saw and lathe and thickness planer... Similarly, one still needs a selection of valuation tools... but for the Long Term investor starting somewhere I would think that the first rough cut is an estimate of economic profitability. After that one can get into market valuation, discounts and premiums, hype and sex appeal and so on... John.

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