The following formulas and such are just some of the methods we use in our investment selection process. Our analysis is always ongoing, which is also known as “dynamic”. We liken the use of formulas and analysis, as a road map. The map changes continuously. The key to this type of analysis is to understand the big picture. The understanding of the big picture is known as, “seeing the forest and not the trees”.
1.Return on Equity (ROE) – Some consider this an evaluation of management skill. How does management deploy assets, generate profits, and deal with margins? Please click on this link to find an interesting article on ROE.
ROE = Net Profit Margin X Asset Turnover X Balance Sheet Leverage
ROE = Net Income X Sales X Assets
Sales Assets Equity
ROE = Net Income
Equity
2. The Benjamin Graham P/E Formula – Click here to see the Graham Dodd P/E Matrix
P/E = 8.5 + 2 (Growth Rate) * 4.4/30 year AAA Corporate Bond Rate
I have tailored the above formula and call it the RBCPA Intrinsic Value Formula.
RBCPA Intrinsic Value = eps* ((2*growth rate)+8.5)*4.4/30 AAA corporate bond rate
3. Times Interest Earned (Interest Coverage Ratio) – This evaluates the ability of a company to meet required interest payments.
Times Interest Earned = pretax income + total interest expense / total interest expense.
We like to see interest coverage at > 4 (or 25% on the inverse). We consider 6 (or inverse 16.67%) as a conservative number.
4. Simple formula to determine years it will take to pay debt is discussed on page 445 of Graham’s Security Analysis.
Total debt / net income
5. David Dreman feels that debt should be less than 20% of Equity.
6. Here are just a few of the many items we look at in financial statements
- Compare earning to consensus estimates
- Compare earnings, revenues, margins, SG&A, and cash flows to prior periods.
- Consider the following calculations
- Allowance for DA / Accounts Receivable
- Allowance for DA / Sales
- Change in Net Income / Change in Cash Flow
- EPS / Debt per Share
- Look at tax rates. did earnings change because of tax rate changes.
- Look at shares outstanding. Watch carefully for dilution. Look at Statement of Cash Flows for true operating and free cash flow.
- Look at “one time charges”. If they are recurring in nature, consider using them as normalized expenses.
7. Earnings Ratio – This is the inverse of the Price Earnings ratio (PE). Intelligent Investor by Benjamin Graham (pg 186 of 4th edition) indicated that this should be as high as the AA 30 year bond rate.
Earnings Ratio > Current AA 30 Year Corporate Bond Rate
8. Other Graham Criteria from Intelligent Investor . We don’t place as large an emphasis here, yet we certainly look at this.
Current Assets 150% > Current Liabilities
debt < 110% of Current Assets (for industrial companies)
9. Seven Deadly Sins of Corporations
A. Recording revenue to soon
B. Recording bogus revenue
C. Boosting one-time gains
D. Shifting current expenses
E. Improperly recording liabilities
F. Shifting revenue forward
G. Shifting special charges
10. Price / Growth Flow ratio – We will use this ratio when working with companies that have large Research and Development (R&D) expenditures.
Price to Growth Flow Ratio = Price / (EPS + FWD 1Y R&D)
| 5X | Cheap |
| 10 – 12X | Normal |
| > 15 – 20X | Expensive |
11. Flow Ratio – a measure of working capital efficiency.
Flow Ratio = (Current Assets – Cash and Short Term Investments) s/b < 1.25
Current Liabilities – Short Term Debt
12. Cash King – a measure of cash flow
Cash King = Free Cash Flow s/b > 10%
Sales
13. PEG and PEGY ratios – These ratios measure P/E over Growth Rate. The PEGY includes yield in the measurement.
We generally like to invest when PEGS are < 1.
PEG = PE/Growth Rate
PEGY = PE / (Growth Rate + Dividend Yield)
14. Graham Ratio – This is a ratio which I named. Benjamin Graham had a theoretical formula which we refer to. The formula involves book value, hence one needs to consider the differences between “tangible” and “intangible” book value.
Graham Ratio = (price/book value)* PE s/b < 24
15. Various Liquidity ratios –
| Operating Margin | = Cash Flow from Operations over Sales |
| Return on Capital | = Net Income over Total Assets at Book Value |
| Leverage | = Total Liabilities over Market Value of Equity |
| Financing Requirement | = Required Debt Financing over Sales |
| Debt Service Capability | = Free Cash Flow over Total Borrowings |
| Interest Coverage | = EBITDA over Interest Expense |
| ST Liquidity | = Net Working Capital over Sales |
16. Taxable equivalent yield = tax exempt yield/1 – marginal tax rate
Taxable equivalent yield = interest income /1 – marginal tax rate
17. Interest Rate Change X Duration = Change in bond value
18. Return on Invested Capital = Owners Earnings / Invested Capital
According to “The Intelligent Investor” ROIC is as follows:
Owners Earnings = Operating Profit + Depreciation + amortization +/- Non Recurring Costs – Federal Income Tax – Cost – essential capital expenditures (maintenance) – unsustainable income (such as rates of returns on pensions) – cost of stock options (if not already deducted from operating profit).
Invested Capital = Total Assets – cash and short term investments + past accounting charges that previously reduced invested capital.
“An ROIC of at least 10% is attractive; even 6% or 7% can be tempting if the company has good brand names, focused management, or is under a temporary cloud.”
According to “Security Analysis”, this is the definition:
Return on Capital = (Net Income + minority interest + tax-adjusted interest) / Tangible Assets – short term accrued payables.
You can read a study of ROIC at this link.
19. Various Cash Flow Ratios
a. Operating Cash Flow (OCF) = CF from Operations/ Current Liabilities
b. Funds Flow Coverage (FFC) = EBITDA / (Interest + Tax adjusted debt repayment + Tax adjusted Preferred Dividends)
c. Cash Interest Coverage = ( CF from Operations + Interest Paid + Taxes Paid) / Interest Paid
d. Cash Current Debt Coverage = ( operating Cash Flow – Cash Dividends) / Current Debt
e. Capital Expenditure = CFO/Capex
f. Total Debt = CFO/ Total Debt
g. Cash Flow Adequacy (CFA) = (EBITDA – taxes paid – interest paid – capex)/ Average annual debt maturities over next 5 years
h. Cash Flow / Enterprise Value
20. Price = Earnings / (Total Return – Earnings Growth) (You can substitute “E” for “D” )
I was thinking about this formula on December 17, 2009, and frankly it makes no sense to me. Feel free to comment. This could be a flawed formula.
P= E/(K-G) or P= D/(K-G)
P= Stock Price
K= Total Return expected (discount rate)
G= Growth rate of earnings
E= Earnings
D= Dividends
I added this formula on the same date 12/17/09 . I have been meaning to study it. I think it is tied into DCF analysis. It too could be flawed.
P = CF (year 0) + (1+G) / R – G
It looks to me, and I could be wrong, that R would be the Discount Rate. I typically will use a discount rate of at least 10% and most often 15% or higher. I got this formula from Hamilton Lin. He mentioned it only works when R > G.
21. Cap rates:
Value = NOI/Cap Rate
NOI = Revenues less Operating expenses
NOI does not include depreciation, amortization, interest and capex.
21. Al Meyer’s Price to Sales Ratio Rule of Thumb
| Net Margin | Price/Sales |
| 5% | 1X |
| 10% | 2X |
| 15% | 3X |
| 20% | 4X |
| 25% | 5X |
| 30% | 6X |
22. Strong Balance Sheet Rule of Thumb I saw.
CA – CL = WC > LT Liabilities = Strong Balance Sheet
23. Inventory Turnover Calculations:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Average Days in Inventory = 365 / Inventory Turnover Ratio
24. EBITDA Coverage Ratio:
Apparently Templeton liked using leverage ratios.
EBITDA Coverage Ratio = earnings + interest expense + taxes + depreciation / Interest Expense. He calls 6 a conservative benchmark.
He then used Total Debt to Trailing 12 Months EBITDA and feels a ratio of 3 or less is a conservative benchmark.
25. Goodwill/Tangible Assets > 20% – Watch for potential impairments.
26. I attended this session 5 years ago. I’ve been busy ;-), so I am just getting to transcribing the notes now. Really good stuff. Mulford is good at quality of earnings and cash flows. He has a few awesome books. One is “The Financial Numbers Game: Detecting Creative Accounting Practices,” and the other is, “Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance.”
Here are notes to this session. There were some areas I may have taken or recalled incorrectly.
A. Look at PPE / Revenue Days.
B. Look for gaps between cash flow and earnings. Always ask why CF is different than EPS. Why are rates of growth different?
C. Look at sustainability of Cash flow.
D. Look at % of costs incurred being capitalized.
E. Cash Flow From Operations – He subtracts Capex. (nothing earth shattering there.)
F. Recast Cash Flow Statement with Balance Sheet changes.
G. Look at Capital Lease disclosure. Perhaps you will find further capex, not identified in Statement of Cash Flows.
H. Look at Securitizations.
I. Don’t add back Tax Benefits of Non-Qualified Stock Options if taxes are not being paid.
J. EQI = Earnings Quality Indicator . Will vary around a general trend. Use normalized CF and NI.
EQI = (CF-Income) / Revenues
or EQI = (OCF/Revenues) – (NI/Revenues)
27. James Montier likes the following Ben Graham Formulas:
A. Earnings Yield should be 2X AAA bond yield. I would use 5 year and 10 year.
B. Dividend Yield should be at least 2/3 AAA bond yield. I would use 5 year and 10 year.
C. Total Debt < 2/3 Tangible Book Value.
28. Selected Formulas from ‘Analysis of Financial Statements’ 5th Edition , Bernstein & Wild.
| Total Debt to Total Capital = (Current Liabilities + Long Term Liabilities) / (Equity Capital + Total Liabilities) |
| Long Term Debt to Equity = Long Term Liabilities / Equity Capital |
| Return on Total Assets = (NI + Interest Expense (1-Tax Rate) / Average Total Assets |
| Cash to Current Liabilities Ratio = (Cash + Equivalents + Marketable Securities) / CL |