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Just as we did Friday for the S&P 500, for our small cap focused readers we are providing a list of the top 20 performing stocks in the Russell 2000 as well as a sector breakdown of the YTD returns from the index to keep up to date on which companies and sectors have lead the way thus far through 3 quarters of 2009. Also by using The Applied Finance Group’s (AFG's) research and valuation model we have provided further analysis on 4 of the top performing companies, 2 that we find attractive going forward and 2 that we find unattractive, based on valuation attractiveness, expected improvement in economic profitability and the overall investment attractiveness, which is based on various criteria AFG uses when identifying long/short opportunities.

Top 20 Returns (YTD) - Russell 2000

2009 YTD Sector Performance (average return %) Russell 2000

Here are a few companies from the list of top 2009 returns and we view these companies going forward based on valuation, Economic Margin Improvement, and other criteria AFG uses to value securities.

 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.

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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.

Last week we took a look at the top performers in the S&P 500; today we're going to highlight the top performers in the Russell 2000 year-to-date and show you which companies look the most attractive according to The Applied Finance Group (AFG). AFG’s valuation techniques have proven successful since 1996 at identifying mispriced securities and helping their clients take advantage of those market inefficiencies. Beyond valuation AFG helps clients understand the true economic profitability a company earns by using their Economic Margin methodology.

AFG's Valuation Signal incorporates a concept AFG calls Percent to Target (Percent to Target measures the percent deviation between a stock’s current trading price and AFG's calculation of a company's intrinsic value). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (this model is a robust modified discounted cash flow model that avoids pitfalls of traditional DCF models such as perpetuity and competition).

Economic Margin (EM) corrects distortions caused by traditional accounting policies to give a more accurate assessment of a company's true profitability. It is important to understand the direction a company's EM's are heading because companies expected to improve their Economic Margins have proven to be more likely to outperform than those with EM’s expected to deteriorate. The EM Framework addresses profitability, competition, growth and cost of capital. When factoring in each of these variables, investors can fully assess a company's value. 

AFG's Buy/Sell criteria factors in Economic Margin, Management Quality, and AFG's Valuation Metric. In order to determine Management Quality, AFG scores management on their growth decisions in accordance with the company’s ability to either create or destroy wealth. AFG's Valuation Metric measures a company's Percent to Target (the 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.