BBY

The Applied Finance Group’s (AFG’s) research and suite of investment tools help investors to easily understand a company’s true economic profitability, as well as if the company’s asset management policy is suitable to maximize that profitability. AFG’s Wealth Creation Report (WCR) allows you to visually analyze a company’s historical Economic Margin (EM) level, current EM and expected change in EM based on projections built out by AFG’s default valuation model, which takes into account the total cash flow a company delivers. A company that earns above its cost of capital (positive Economic Margins) and is growing its asset base is considered to be following a wealth-creating strategy. Back-tests have proven these companies to be more likely to outperform those companies following a wealth-destroying strategy (negative Economic Margins and growing assets).

Avoiding firms with management teams who try to grow a negative profitability business has helped our clients since 1996 avoid potential torpedoes in the market. AFG believes that if a firm is not profitable, it needs to divest losers and focus on its core competencies to get its profitability levels back on track and earn the right to grow, rather than throw more money at a losing business. After getting an understanding of how profitable a firm is and which direction the firm’s profitability is headed, investors must then understand how much a company is growing out its assets to take advantage of its current profitability or what to divest in order to fix its profitability.

Beyond having positive Economic Margins (EMs) and growing assets, investors want to see a company improve its EMs at a greater rate than its sector peers, as these companies have also proven to be more likely to outperform than companies with declining EMs.

Below is an example of Best Buy (NYSE:BBY), a company AFG considers to be a consistent wealth creator, identified by using AFG’s Wealth Creation Report.

Best Buy Co., Inc. (NYSE:BBY) – Consistent Wealth Creator

Click Here If you are a professional investor and would like to trial AFG’s research products or to see if you are qualified to have a portfolio reviewed by an AFG representative.

AFG's Wealth Creation Report is a 3part chart:

The first chart is a summary of a company’s economic performance over time, as well as insight into how analyst EPS forecasts project AFG’s default EMs over the next two years.

• EM – Productive Capital = (Cash Flow minus Capital Charge excluding Intangibles) divided by the Inflation Adjusted Productive Capital.

• EM – Invested Capital = (Cash Flow minus Capital Charge including Intangibles) divided the by Inflation Adjusted Productive Capital.

•Val Score = Ranked Percent To Target for the current calendar yr. where 100 is the most undervalued and 0 is the most overvalued (ranked across all firms in database with forecasts for 4,000 firms).

• EM Chg = One year out forecast EM minus last reported fiscal year's EM. Invested Capital EM is used.

The second part of the chart is the Asset Growth chart allows additional insight not only the growth of a company, but how that company’s growth strategy has affected their economic performance.

• Assets – Steady Growth (1 Yr) = The real growth rate at which a firm can increase its capital base given internally generated cash, while maintaining a constant capital structure.

• Assets – Actual Growth (1 Yr) = Real year over year change in Inflation Adjusted Invested Capital achieved by the firm. Note: All actual growth is “actual”, i.e. 2007 growth represents growth from most recent quarterly balance sheet.

This data can then be used to identify how the stock has performed in relation to the market place.

• Return Net Market = The company's cumulative total return relative to the cumulative market-weighted average total return of the largest 2000 companies for the equivalent time period.

Be on the lookout for Weekly company highlights using The Applied Finance Group's Wealth Creation Report.

With the biggest shopping season of the year just around the corner, we thought it would be timely to highlight some consumer sector companies that look attractive according to The Applied Finance Group’s (AFG’s) criteria for investment opportunity attractiveness, as they are in line to benefit from the upcoming seasonal spending patterns. The list of companies we have provided look the most attractive within the AFG consumer sector in terms of valuation attractiveness, economic performance, and overall investment attractiveness relative to their peers.

One of the companies that we feel particularly confident in is the retailer Kohl’s (KSS) which is currently a holding in The AFG 50, (a model portfolio of 50 large cap stocks designed to help Portfolio Managers save time, make more informed investment decisions, and outperform their benchmark). We are confident about Kohl’s competitiveness because they have a strong cash flow, strong execution, and have been outperforming their competition.

Going into this holiday season, consumers will most likely remain thrifty due to the overriding economic conditions, although their confidence levels have improved so far this year. They will search hard for values, being mindful of budget. We continue to believe Kohl’s will remain one of the most successful retailers in this country, as it strives to and succeeds in providing value to consumers with freshness and relevance of its merchandize.

The complete list of consumer stocks we have provided below, which includes the highlighted Kohl’s, are the companies AFG believes are the most likely to outperform. Companies that AFG identifies as having an attractive valuation, improving Economic Margins (AFG’s corporate performance metric) and an attractive investment opportunity signal have proven over time to outperform those companies with unattractive valuations, declining Economic Margins, and unattractive investment opportunity signal.

Source: EconomicMargin.com

AFG's Valuation Metric – Measures the percent to target (deviation between a stock’s current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (modified discounted cash flow model).

Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.

Management Quality – Assesses management’s ability to make wealth creating decisions.

To stay updated on how other professional investor's currently view the market join our Market Forecast Project survey and be among the first to receive the results.

Investors who use The Applied Finance Group’s (AFG’s) research and suite of investment tools have the ability to easily understand a company’s true economic profitability, as well as if the company’s asset management policy is suitable to maximize that profitability.

A company that earns above its cost of capital (positive Economic Margins) and is growing its asset base is considered to be following a wealth-creating strategy. Backtests have proven these companies to be more likely to outperform those companies following a wealth-destroying strategy (negative Economic Margins and growing assets). Avoiding firms with management teams who try to grow a negative profitability business has helped our clients since 1996 avoid potential torpedoes in the market. AFG believes that if a firm is not profitable, it needs to divest losers and focus on its core competencies to get its profitability levels back on track and earn the right to grow, rather than throw more money at a losing business. After getting an understanding of how profitable a firm is and which direction the firm’s profitability is headed, investors must then understand how much a company is growing out its assets to take advantage of its current profitability or what to divest in order to fix its profitability.

Beyond having positive Economic Margins (EMs) and growing assets, investors want to see a company improve its EMs at a greater rate than its sector peers, as these companies have also proven to be more likely to outperform than companies with declining EMs. AFG’s Wealth Creation Report (WCR) allows you to visually analyze a company’s historical EM level, current EM and expected change in EM based on projections built out by AFG’s default valuation model, which takes into account the total cash flow a company delivers.

Below are a few examples of companies AFG considers to be following wealth-creating or wealth-destroying strategies, identified by using AFG’s Wealth Creation Report.

Best Buy: Consistent Wealth Creator

Amphenol Corp: Consistent Wealth Creator

Cognizent Technology Solutions: Consistent Wealth Creator

Southwest Airlines: Consistent Wealth Destroyer

Micron Technology: Consistent Wealth Destroyer

Electronic Arts: Growth at the expense of its Economic Margins (Wealth Destroyer)

AFG's Wealth Creation Report is a 3 part chart :

The first chart is a summary of a company’s economic performance over time, as well as insight into how analyst EPS forecasts project AFG’s default EMs over the next two years.

• EM – Productive Capital = (Cash Flow minus Capital Charge excluding Intangibles) divided by the

Inflation Adjusted Productive Capital.

• EM – Invested Capital = (Cash Flow minus Capital Charge including Intangibles) divided the by

Inflation Adjusted Productive Capital.

•Val Score = Ranked Percent To Target for the current calendar yr. where 100 is the most undervalued

and 0 is the most overvalued (ranked across all firms in database with forecasts for 4,000 firms).

• EM Chg = One year out forecast EM minus last reported fiscal year's EM. Invested Capital EM is used.

The second part of the chart is the Asset Growth chart allows additional insight not only the growth of a company, but how that company’s growth strategy has affected their economic performance.

 • Assets – Steady Growth (1 Yr) = The real growth rate at which a firm can increase its capital base

given internally generated cash, while maintaining a constant capital structure.

• Assets – Actual Growth (1 Yr) = Real year over year change in Inflation Adjusted Invested Capital

achieved by the firm. Note: All actual growth is “actual”, i.e. 2007 growth represents growth from most

recent quarterly balance sheet.

This data can then be used to identify how the stock has performed in relation to the market place.

• Return Net Market = The company's cumulative total return relative to the cumulative market-weighted

average total return of the largest 2000 companies for the equivalent time period.

 

About Economic Margin

 

Created by The Applied Finance Group,  The Economic Margin (EM) Framework was developed to evaluate corporate performance from an economic cash flow perspective and is an alternative to accounting-based valuation metrics. EM measures the return a company earns above or below its cost of capital and provides a more complete view of a company’s underlying economic vitality

 

Value-based metrics (as opposed to accounting-based methods) have become popular for two reasons. First, capital markets have forced money managers and corporations to have a renewed focus on the balance sheet; these companies are expected to provide an adequate return on the money they have invested. Second, accounting information, although necessary, does not by itself adequately explain market valuations nor provide comparability between firms.

 

EM is meant to serves two purposes: Create an measure of a company’s economic profitability; that is, did this company generate cash flow in excess of the costs of its capital invested in its operations, or did the company destroy wealth? Once we have solved for this, we can then use this EM as a function in our valuation model.

 

EM is calculated by dividing a company’s Operating Cash Flow minus Capital Charge by their Invested Capital. For a more detailed explanation see below.

 

 

Economic Margin Framework is more than just a performance metric as it encompasses a valuation system that explicitly addresses the four main drivers of enterprise value: profitability, competition, growth and cost of capital.

 

Economic Margin captures the relevant drivers that are necessary to evaluating corporate performance and identifies wealth creating firms as well as wealth destroying firms while focusing on the key issues that drive market valuations. The EM also incorporates risk through a capital charge on all of a firm’s cash flow while also providing an annual snapshot to evaluate company track records creating and destroying wealth to evaluate current company actions.

 

Correcting Common Accounting Distortions

 

Accounting-based valuation methods provide an incomplete view of a company’s value by not accounting for investment to Generate the Earnings, Cost of Capital, Inflation or Cash Flow.  Because the EM corrects these accounting distortions by taking into account Asset Life, Asset Mix, Asset Age, Capital Structure and Growth , effectively linking the income statement and balance sheet, EM levels have a much higher correlation with market Values. 
 

 

A company’s performance measure must serve as a proxy for its market value creation.  Successful corporations consider cash flow, investment, competition & risk when setting strategy with the goal of creating shareholder value.  But not all management teams are successful at creating shareholder value.  As displayed on the graph below, AFG's Economic Margin can help invesmtent managers clearly distighigh managment teams abilty to create shareholder value.

 

Below is a comparison between Best Buy (BBY) and Circuit City (CC). Not surprisingly, soon after we took a snapshot of Circuit City’s Wealth Creation report they filed for bankruptcy.

Source (The Applied Finance Group)


Source (The Applied Finance Group)

 

 

The average company in the United States generates an Economic Margin of zero.  Below is a list of companies that have been able to generate EM's greater than 10% on average over the past three years.  Although all of the companies listed have had great success in generating a large spread above their cost of capital, some of these companies are classified as unattractive because they have started to trade at a premium to their intrinsic value and the direction of those Economic Margins is unattractive. (Receive Our Stock Reserch Alerts by email)

High EM Buys & Sells

Source (The Applied Finance Group)

 Next week we will be discussing the use of an Economic Margin as a complete valuation system.

AFG's Economic Margin framework is more than just a performance metric, as it encompasses a valuation system that explicitly addresses the four main value drivers of enterprise value: profitability, competition, growth, and cost of capital. Unlike traditional valuation approaches that utilize highly sensitive perpetuity assumptions, our approach incorporates the widely accepted economic principle that competition will compete away excess returns over time.

One of the simplest ways to use an Economic Margin is to evaluate a management’s ability to create wealth for their shareholder value.  Below is a comparison between Best Buy (BBY) and Circuit City (CC).    Not surprisingly, soon after we took a snapshot of our of Circuit City’s Wealth Creation report they ended up filing for bankruptcy.

Best Buy Wealth Creation Report
          

Circuit City Wealth Creation Report
          

Fortune magazine recently put out an article listing the most admired companies in the world.  We took the top 50 firms (excluding Financials, and companies not traded in the US) on their list and put them through Applied Finance Group's quantitative recommendation framework.  Just because these firms are among the most admired companies in the world does not qualify them as the most attractive investment. Being among the most admired is an honor and means you must be doing something right, but might not necessarily mean the share price is currently attractive. 

The following articles which we have posted in the past on ValueExpectations.com will give you a better understanding of what it takes for management to create wealth, understand Management Quality, and see how EPS alone falls short in estimating a company’s value. There are two main characteristics a company must have in order to be a good investment opportunity: (1) the company needs to be a strong economic performer, (2) the company should be attractively priced.   Many people admired the DeLorean, but it was neither a good performing car nor a good priced car. Below we reveal a few "DeLoreans" after looking under the hood.

Top 50 Most Admired Companies According to Fortune

In life, the most attractive people are in shape and have good looks, just look at Hollywood. The same is true the majority of the time in investing. The most attractive stocks have healthy financial statements and look good from a valuation standpoint.

The Altman Z-score is a metric that gives insights into the likelihood of a firm going bankrupt in the next 2 years. The model was developed by Professor Edward I. Altman of the NYU’s Stern School of Business and first published in The Journal of FINANCE in September 1968. A common critique to this metric is that it was developed over 40 years ago and is no longer relevant.

In 2001, Professor Joseph D. Piotroski of The University of Chicago Graduate School of Business, published a paper called, Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers. Piotroski showed that value investors were rewarded by looking at a firm’s financial health and he showed that Z-score was a meaningful statistic.
More recently, on December 5, 2008, Dr. Altman was called to testify before a House of Representatives Committee on the condition of U.S. Automakers. In his testimony, he noted that Bloomberg, Inc. reported, “that approximately 1,000 users of their system per day access the Altman Z-Score model.”

The Altman Z-Score breaks down firms into 3 zones:
• >2.99 – Not Likely to Go Bankrupt
• 1.8 - 2.99 – Gray Area
• <1.8 – Likely to Go Bankrupt in the Next 2 Years

Using AFGView.com, we screened for firms that looked relatively attractive from a valuation perspective and had an Altman Z-Score above 2.99. Below is a list of those firms. Later we will look at firms that are expensive and have a Z-Score below 1.8.

Sales Expectations for Companies with an Attractive Valuation and Healthy Balance Sheet

Nearly all of the biggest return earning companies in the S&P 500 are firms that have been beaten up over the past few months but have bounced back to provide the biggest return in the entire index for the month of December. These firms have ended 2008 on a high note and move into 2009 with what they hope to be sustainable momentum.

The list of companies in the S&P 500 with the worst returns in December had also been trending downward for the past few months but were unable to muster a year-end turnaround as those on the other list had been able accomplish. Many of the firms on this list have something to do with oil, as their stock prices have been highly correlated with the falling price of oil.

Compare the sales growth priced-in to justify the current stock price (VE Sales Growth), to what the company has been able to deliver the past 5 years in revenue growth (5 Year Median Sales Growth), to see which companies have reasonable expectations of achieving the Sales Growth priced-in. Companies with low expectations relative to what they have been able to achieve are more likely to out-perform.

Sales Growth Expectations for the Highest Return Companies (S&P 500) - December

**denotes only 2 years historical sales growth available (2 year median used)

Sales Growth Expectations for the Lowest Return Companies (S&P 500) - December

VE Sales Growth Calculated for these firms on 12/26/08.