How to Read the Performance & Valuation Prime Chart

The Importance of Embedded Cash Flow Expectations

Embedded in every company’s stock price is the market’s forecast for the future performance of the firm. If the company beats that performance, the stock price goes up relative to the broader market. If the company fails to meet that performance, the stock price falls.

The Performance and Valuation Prime Chart in one place helps explain the company’s corporate performance over the past 10 years, the value the market has ascribed to the company historically and currently, while also explaining how the company has performed relative to the market.

This is an ideal starting point for the understanding of a company’s operational and market context.

Reported financial statements are a mess and earnings can go up and down because of hundreds of “non-cash” items that can make it extremely difficult for any investor to figure out. Thankfully, cash is still king. In the long run, the stock market prices company stocks based on the cash flow generating ability of the firm, not the accounting-distorted earnings.

For a long-term fundamental investor, understanding the embedded cash flow expectations in the stock price is key. The reported earnings may or may not even be relevant. As we see so often, there are companies with negative earnings that are priced with enormous valuations, and companies with solid earnings that are priced so cheaply. The problem is the inconsistency in the earnings.

Performance and Valuation Prime Charts were built to provide three cash-based assessments of the market’s valuation. These are based on cleaned-up, scrubbed, cash-based V/E’ multiples, V/A’ multiples, and DCF or Discounted Cash Flow models. An investor can better judge a stock as “expensive” or “cheap” when the accounting distortions have been removed and valuations have been triangulated across these three models. (Note: the apostrophe after the V/E’ and V/A’ is the symbol for “prime,” meaning “adjusted.” These calculations have been modified with comprehensive adjustments to remove accounting and computation distortions found in traditional calculations of these metrics).

The ROA’ Panel Shows Historical and Forecasted Company Performance

ROA’ is the abbreviation for “Return On Assets Prime.” The ROA Prime is a measurement that is calculated after the balance sheet, income statement, and statement of cash flows have been thoroughly adjusted to create an apples-to-apples set of financial information. An advanced ROA computation is then applied which corrects for many formulaic biases and flaws in traditional Return on Asset and Return on Capital Employed computations. Hence, the name “ROA Prime,” with the mathematical notation for “prime” as ROA’.

The ROA’ explains the cash return that management generates on each dollar of cash it invests into the company. For this reason, the term ROA’ is used interchangeably with the term “cash flow return,” or simply, “returns” of the company or business. (For more, see the Institute’s publications, “When Cash Is Not Cash and Why” and “How to Calculate an ROA”)

The ROA’ panel of the Performance & Valuation Prime™ Chart demonstrates the firm’s annual cash flow returns over a decade of history. Two forecasted years are shown after the last full fiscal year (“LFY”), both marked with an 'E' to indicate that they are estimates. Calculations are based on publicly-available consensus analyst forecasts of firm sales, net income, capital expenditures, and other information. These are the Institute’s assessment of what consensus analyst estimates suggest for forecasted ROA’s.

Of utmost importance is the “Mkt” bar representing the Market-Implied ROA’ which is the last bar in the bar chart, and shows in white when viewing the chart in color. This Market-Implied ROA’ is determined by solving for the ROA’ that is the “embedded expectation” of the current trading stock price level. The Institute’s computation takes readily available public information and “backs into” the long-term ROA’ forecast implied by the stock price. This is incredibly valuable for assessing a company’s potential stock price upside/downside.

On the next page, we delve into various nuances of understanding ROA’ levels, relative to the company’s stage in business life cycle, cost of capital, corporate averages, and forecasts.

Understanding ROA’ Levels and The Importance for Business Strategy Evaluation

The ROA’ explains the cash return management generates on each dollar of cash it invests into the company. The ROA’ is Earnings Prime divided by Assets Prime, with many adjustments to remove accounting distortions. The term ROA’ is used interchangeably with the term “cash flow return,” or simply, “returns” of the company. For more, see the Institute’s publications, “When Cash Is Not Cash and Why” and “How to Calculate an ROA.”

The ROA’ is fundamental to understanding where a firm is in its life cycle, relative to its cost of capital, and knowing how that should impact the firm’s business strategy. Early stage companies tend to generate an ROA’ below their cost of capital, betting that future ROA’s will be far higher than the cost of capital. More mature firms can demonstrate higher ROA’s.

Companies that generate an ROA’ above the cost of capital are creating value above the required rate of return of their Assets Prime and should thus be grown so long as the incremental rate of return on new capital spending continues to be above the cost of capital. Companies that produce returns below the cost of capital are not producing sufficient returns on their Assets Prime. In those cases, that capital would be better used if re-allocated to businesses that can produce superior returns.

As a real ROA’ calculation, the comparable cost of capital for the business is generally around 5.0% to 6.5% for most companies, depending on the firm’s leverage, size, and a number of economic issues within the industry and markets in general. Note that this is lower than a traditional Weighted Average Cost of Capital taught in most schools of thought because most schools leave inflation in the cost of capital.

The final white bar explains the market’s “hurdle rate” of what is priced-in to the current valuation of the firm as of the date of the report production. When assessing the firm’s valuation level, the bar suggests the market’s level of performance expectations for the firm. Changing expectations for performance above that white bar’s level can generate significant increases in valuation and therefore, stock price. A low bar is a low hurdle. A high bar is a high hurdle, requiring higher performance to generate increased valuation levels.

Asset’ Growth stands for “Asset Prime Growth” and is the real annual growth rate of the cleaned-up and properly adjusted Asset’ base of the company. This metric explains the management team’s propensity to reinvest over time. When viewed in the context of the ROA’, the growth rate explains a lot about management’s intended strategies and even performance incentives.

Asset’ Growth is a real metric, meaning it is adjusted for changes in currency levels, generally inflation. Asset’ Growth can come in the form of organic growth, where a firm simply purchases new assets through capital expenditures. Asset’ Growth can also come from acquisitions. Negative growth can come from divestitures, or simply assets aging, leaving the books, without replacement. If a firm shows capital expenditures that are just enough to replace assets that are aging, the chart should show a zero growth rate.

Companies that generate an ROA’ above the cost of capital are creating value above the required rate of return of their Asset’ and should thus be grown. With the exception of start-up firms where longer-term forecasting horizons are common, companies that display growth when ROA’s are above the cost of capital generate increased value. If companies do this in excess of what the market expected, the market’s valuations and stock price will increase. Firms that grow when ROA’s are below the cost of capital will destroy economic value. If this is done in excess of the market’s forecast for value destruction, valuations and stock prices go lower. When firms grow at rates of return that match the cost of capital, no economic value is created. Valuations tend to stagnate.

The final white bar for Asset’ growth in the second panel is a best guess calculation of the expected growth rate of the firm’s balance sheet, its Asset’ growth rate. This estimate is based on a combination of management guidance, consensus analyst estimates of growth, and the particular management team and industry’s growth patterns. The market-implied ROA’ in the first panel is dependent on this growth estimate and can be adjusted if the growth estimate is believed to be too high or low for whatever reason.

V/A’ is a calculation comparing the value (V) of the company to the Asset Prime (A’). The V is the market capitalization of the company plus the total debt of the company, including off-balance sheet debt. The A’ reflects the total Asset Prime of the firm, necessarily adjusted for problematic accounting standards for reporting of the balance sheet. V/A’ can be thought of as a very “cleaned-up” Price-to-Book metric. The A’ is the same as the denominator of the ROA’ calculation.

Throughout the 50+ years of history and across industries and countries, there continues to be a tremendously strong relationship between ROA’ levels and V/A’. In other words, firms that generate higher cash flows relative to their investment base experience higher market valuations relative to their investment base.

The historically strong relationship between valuation levels and firm “quality” – between V/A’ and ROA’ – creates an opportunity for evaluating valuation levels very quickly. The empirical, observed relationship between quality and valuation when measured this way is amazingly intuitive and logical.

The market tends to value V/A’ at “1” when the firm generates an ROA’ at the cost of capital. In other words, firms trade near their “book value” when their returns are merely at their cost of capital. When the firm’s cash flow returns sustain double the cost of capital, the valuations tend to be double the book value, and so on. Again, the observation is extremely intuitive and even somewhat serves as a proof of the necessity for “cleaning-up” the accounting data. Relationships between traditional Price-to-Book metrics and other return metrics are seldom so logical.

Interestingly, there appears to be a “floor” for valuations, regardless of how negative returns can go. V/A’ tends to not fall substantially below 0.6 unless there is a risk of credit default or bankruptcy. When V/A’ is far above the traditional relationship to ROA’, it does not necessarily suggest overvaluation. It suggests that investors forecast for future ROA’ improvement and growth could be far higher than traditional firms, such as in earlier growth stages of companies.

Fwd V/E’ is a cleaned up, forward-looking Value-to-Earnings metric. The numerator is the Enterprise Value of the firm, and therefore the same V from the V/A’ metric. The denominator which is the adjusted earnings number is the same calculation as in the numerator of the one year forward ROA’ calculation.

Over the duration of an economic cycle, V/E’ tends to be 15x to 20x, based on the market’s expected sustainability of the cash flows the company is expected to generate. Start-up firms in early stages of growth can show extremely high and even negative V/E’ multiples. Companies with extremely “bad years” of performance can also show such negative V/E’ valuations as the market “sees” through the near-term problems and attempts to value the firm based on longer-term future cash flow streams. In both of these cases, the value of deconstructing the V/E’ into V/A’ and ROA’ can be far more useful.

V/E’ is very similar to a traditional V/E in its use. V/E’ is useful on an absolute basis; low V/E’ firms have low expectations of future performance by the market. High V/E’ firms have high expectations of future performance in terms of growth and returns. One should be careful not to judge high V/E’ firms as immediately “overvalued” or low V/E’ firms as undervalued. The measure merely reflects the forecasted future cash flows of the firm relative to the one year forward performance expected.

The V/E’ can be useful as a relative valuation tool, comparing it against a company’s peers in its sub-industry, industry, sector, and relative to its historical valuations. If a company is trading at a substantially lower V/E’ than it has historically, though fundamentals such as ROA’ and Asset’ growth have not changed, the company may be undervalued, and visa versa.

The combination of triangulating three distinctly different valuation models on one chart can be powerful in understanding the expectations of the market form different perspectives. The market-implied ROA’ is based on Discounted Cash Flows. The V/A’ is valuable in the context of the ROA’s of the firm, and the V/E’ can be examined like a traditional P/E would be for comparing valuation levels.

Total Shareholder Returns (TSR) Relative are traditionally known as the capital gains of the stock, adjusted for any stock splits or similar action, plus dividends, over some period of time. No adjustments are made to the well-known standard calculation.

TSRr calculates the TSR relative to the performance of the S&P 500 in the USA, or some other major market index (if it’s more relevant) when examining companies in other countries. If the stock returns 20% in capital gains and dividends in a year, and the market returns the same 20%, then the TSR Relative will show the company’s TSR as flat or horizontal in the chart for that year.

When the Relative TSR is above 1x for any given period, the line is sloping upward, and it means that the company’s TSR has outperformed the market. When the line is sloping downward for any given period on the chart, the company’s TSR has underperformed the market.

It is very possible that in years where the market shows high returns, the TSRr of the company can slope downward, and yet have still posted positive stock returns in absolute value – and vice versa. Firms that continuously “surprise” the market with ROA’s and Asset’ growth rates in excess of the market’s expectations will see the firm’s TSRr slope upward for that same duration of time. A firm where expectations were already very high for future ROA’s and growth, and which succeeds in meeting that expectation, will see the TSRr slope evenly with the market. Meanwhile, a firm with very low expectations of performance, which simply surprises the market with mediocre performance levels, and yet still above prior expectations, can see TSRr slope upward precipitously.

Great companies are often not great stocks, and vice versa, depending on expectations.

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