Ernst & Fotta's Dual Cash Flow Analysis, A Forbes Report:
There are paper earnings and then there are
hard-cash earnings. You want the latter, says
Ernst Institutional Research. How do the Forbes
500s companies stack up?
Reality check
By Michael K. Ozanian
SAY "BLUE CHIP" and you probably think
about the level or the growth rate of a company's
earnings. On those scores, the big outfits that
appear on one or more of the Forbes 500 lists are
doing fine. Their combined earnings of $357
billion last year came to 6.3% of revenues and
were up 7% over the year before.
Earnings growth is good, but it's not enough.
Earnings quality matters, too. What do we mean
by quality? Imagine two companies, each netting
$100 million on sales of $1 billion. Company A
banks the $100 million. Company B plows back
every penny into operating assets_factories,
equipment and inventory. Over time, for all its
furious investment, however, B displays no
growth in revenue or net income. In its
profitmaking and reinvesting it is just treading
water.
Company B has an earnings quality problem.
Investors who focus on earnings per share may
love the company at first, but sooner or later they
are going to wake up to the fact that they can't
take those earnings to the grocery store. If B pays
a dividend, it is either depleting a bank account or
borrowing money in order to do so. Someday the
money is going to run out. This could happen even
as the reported earnings continue to gush in.
Alas, no companies have financial pictures as
clear as those of Company A and Company B. In
the real world, you can readily ascertain how
much cash flow a company generates (in the
sense of earnings plus depreciation), and you can
get its capital expenditure figure, and you can
compare the two. But what you don't know is
how much of the capital expenditure went for
genuine expansion and how much did nothing
more than allow the company to maintain its
existing activities.
Intel makes a mint, but also spends a lot on new
chip factories. How much of those outlays merely
enable Intel to run in place? You really don't
know, unless you know a lot about the computer
business.
A Question Of Quality
Based on P/E ratios, Wall Street analysts don't
expect much from the Forbes 500s companies
included in the first table below, and have big
expectations for the second table. But as
measured by Ernst's cash flow model, the
companies in the top group have improving
trends in sales growth, operating margins and
return on assets indicating that the quality of
their earnings is high. The companies in the
bottom group seem to be less effective at
generating returns from their assets.
Company
1998
P/E
estimated
EPS
Airborne Freight
16
$2.48
AMP
17
2.38
AMR
12
12.31
BankAmerica
17
4.86
Countrywide Credit Inds
15
3.16
Federated Dept Stores
17
2.98
Golden West Financial
14
6.75
Navistar International
13
2.58
Tidewater
9
4.89
Yellow
11
1.92
Company
1998
P/E
estimated
EPS
Boston Scientific
36
$1.90
Emerson Electric
23
2.79
Frontier
25
1.23
Medtronic
34
1.52
Novell
49
0.21
Pharmacia & Upjohn
26
1.61
Reader's Digest Assn
47
0.54
Tandy
21
2.15
Times Mirror
23
2.75
Wal-Mart Stores
29
1.77
Still, investors must do the best they can to detect
which companies are generating spendable
cash_and which are not. For this purpose one of
the more intriguing formulas we have seen comes
from Ernst Institutional Research, a Boston
boutique that sells quality-of-earnings analyses to
Fidelity Investments, Colonial Funds and others.
The original author of the Ernst formula is Harry
B. Ernst, a Harvard-trained economist and a
former professor of accounting who developed
the Federal Reserve Board's model for its
industrial production index.
Ernst's formula starts by comparing a company's
growth in net worth over the course of a year to
its growth in operating assets (basically: plant,
equipment, inventory). You subtract the latter
from the former. The result is a crude measure of
the outfit's free cash flow. Putting aside for a
moment the possibility that a dividend has been
paid, the difference in these two numbers
represents the amount of cash that has piled up
from the business. Say Company C earns $100
million, generates $80 million from depreciation
charges, pays no dividend and spends $150
million of its cash flow on a new fleet of trucks.
The growth in the company's net worth in this
example is $100 million; the growth in the
business assets is $70 million ($150 million of new
trucks minus $80 million of wear and tear).
Subtract $70 million from $100 million and you
get $30 million_the cash that has piled up from
the business.
For simplicity, we have ignored working capital
fluctuations from receivables, payables and the
like. Let's move on to the third important element
in the Ernst formula. Take the $30 million figure
and subtract the growth in liabilities. This is a
somewhat arbitrary part of the formula, aimed at
penalizing outfits with deteriorating balance sheets.
In our hypothetical example there is no change in
liabilities.
Last step: Divide the $30 million by sales to get a
percentage figure. If C's sales for the year were
$1 billion, you'd have a 3% ratio. The point of this
step is to allow for the fact that a company with
growing sales probably can't avoid expanding its
business assets at the same pace_but also should
be keeping up the pace in retained earnings.
Okay, Company C has a 3% ratio. Now what?
By itself, explains Jeffrey Fotta, a managing
director in the Ernst firm, this is a meaningless
figure. What he looks for is an upward or
downward trend in the ratio over a period of ten
years. A rising ratio, he says, is likely to be found
in a company whose earnings are more than
keeping pace with its growth in revenue and
capital expenditures. A company with a declining
ratio may be destined to go into hock to pay its
bills.
You'll notice some quirks in the Ernst formula. A
company's ratio in any one quarter would be
forced down by an outsized dividend increase_
even though most investors would not rate a
dividend increase as a bad thing. Also, the
formula double-penalizes companies for
debt-financed expansions: once in increased
business assets and again in increased liabilities.
But this would not lower a company's rating
unless the assets proved unproductive, because
the formula measures trends over such a long
period of time. Last summer the Ernst formula
flagged Oxford Health for a declining cash ratio
trend over several quarters_at a time when
Oxford was reporting terrific earnings. To be
sure, Ernst had no idea what was really going on,
which was that Oxford was understating what it
owed to doctors, and thus overstating its earnings.
But the formula perhaps picked up some financial
rumblings before the earthquake. The stock lost
two-thirds of its value in October when the
problem with the payables came out.
One way to use Ernst's formula is to compare a
company's cash flow trend to its valuation.
General Electric and Microsoft have excellent
cash flow trends, according to Ernst. But they
sport 1998 estimated price/earnings ratios of 28
and 50, respectively, against a median of 19 for
the Forbes 500s. So their strong fundamentals are
already reflected in their stock prices. Hercules
Inc. and Eastman Kodak have declining cash flow
trends. But their deteriorating balance sheets are
already reflected in their multiples, which are both
15.
The trick is to find companies with improving cash
flow trends and reasonable prices. The table at
the far left shows ten Forbes 500s companies
with both very positive cash flow trends and
estimated P/Es below 18. The other table lists ten
companies with deteriorating cash flow trends as
well as estimated 1998 P/Es of 21 or higher.
We'll revisit these lists next year. |
