CF

Traditional Discounted Cash Flow (DCF) models have been been underutilized in equity analysis over the years primarily because of the assumptions one has to sign off on. We will concentrate on just two of the major issues we have with traditional DCF models, the lack of ability to deal with competition and the perpetuity assumption embedded in a DCF model. These assumptions lead to irrational calculations of intrinsic value and force analysts to make compromising decisions in their model building efforts.

AFG uses a modified DCF model that accurately addresses the competitive nature of the business while also dealing with the perpetuity issue through our Economic Margin decay or competitive advantage period.

The four factors that affect AFG’s Competitive Advantage Period (CAP) are;

Profitability – High Profit leads to increased competition and a higher decay rate
Variability – Higher volatility leads to less predictability and a higher decay rate
Trend – AFG gives the benefit of the doubt to an upward trend which leads to a lower decay rate
Invested Capital – Large Invested Capital creates barriers to entry and leads to lower decay rate

The Decay Rate is the rate at which the Economic Margins™ will diminish over time due to competition, market conditions and limited investment opportunities. Higher decay rates translate into shorter competitive advantage periods, while lower decay rates translate into longer competitive advantage periods.

The Decay Rate profile is downward sloping to the right, which means that Economic Margins™ over time diminish to zero. This does not mean that the company will not have earnings, but instead the company will have an Economic Margin™ of zero, which indicates there are no excess profits after the investors are paid and the depreciating assets are replaced.When selecting securities, companies that are maintaining a high level of economic profitability or growing their profits rapidly are attractive from an investment standpoint. However, the more profitable a firm is the more likely other companies will attempt compete away excess returns.

To illustrate this, one has to look no further than Dell Computer. Dell Computer had Economic Margins™ hovering around 40% (top 5% of all companies) in 1997 and 1998, but soon every major firm was announcing that they were going to build computers to order. Why? Because they saw the huge profits that Dell was making. The result is that Dell's Economic Margin™ for 1999 was around 25%, a decline of 37.5% in just one year. The remaining factors are relatively straight-forward, in that volatile returns are worth less than consistent returns, companies with an increasing Economic Margins™ are worth more than a company in decline, and large companies have a natural barrier to entry, thus a lower decay rate.

Theory: Excess return gets competed away

Fact: In 1997, the median top decile Economic Margin (EM) firm = 17.4%. 10 years later, that same group of companies had a median EM of 6.5%. On the other hand, the bottom decile had an EM of -12.2%, 10 years later that same group had a median EM of -1.0%.

Current Top Decile Economic Margin Companies (S&P 500 ex. financials)

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With the first quarter of 2009 winding down, ValueExpectations.com has compiled a list of the best and worst performing stocks thus far in 2009 (excluding financials). It is not surprising for us to see two companies on the top performer list (S and MYL) that also appeared on our list at the end of January, or three bottom performing companies (ODP, TXT and MTW) still remaining on the bottom performer list over a month and a half later. We published an article in early February highlighting the top and bottom performers for the month of January and posed the question “Is the January Effect effective?”

Top 10 S&P 500 Companies (YTD 2009)

Bottom 10 S&P 500 Companies (YTD 2009)

Our conclusion: Looking at the YTD returns for the companies in our January effect article's top and bottom lists, we notice that there is a huge spread. January’s top performers have earned an average return of 4.66% YTD compared to January’s bottom performers’ average YTD return of -57.15%. This pretty compelling spread suggests that the January effect may be something investors want to pay closer attention to next year and it may even be helpful for the remainder of 2009.

*AFG’s Value Expectation allows us to understand the imbedded Sales Growth, EBITDA Margins, and Asset Turnover a company has to deliver in the future to justify its current trading price. In theory and in normal circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued. The table displays the implied future sales growth of companies assuming their EBITDA margins and Asset turnover stay constant at the company's historical 5 year median.

There are many ways professional equity investors use to narrow their list of investment constituents; by size, value, growth, sales growth, earnings growth, etc. When ValueExpectations.com looks for investment opportunities or to avoid potential torpedoes, we start with a focus on accessing Valuation, Corporate Performance (Economic Margin), and Management Quality of companies. These variables have proven very successful in finding winners and avoiding losers in different market caps, different styles, and different economic sectors, helping professional investors make sound stock selections in the past 13 years. These and many other proprietary variables can be screened on Applied Finance Group’s (AFG’s) institutional product www.AFGView.com.

Enjoying an accomplished methodology and process of selecting stocks doesn’t prevent us from learning how other people are identifying their fishing pool. We recently came across SA Editor Eli Hoffman's recommended list of stocks based on a set of variables that , he believes benefit both growth and value investors as these companies contain characteristics both investors will find attractive. These stocks were identified by what the author calls “a powerful screen and helps find strong companies at great values”.

Eli Hoffman's screen includes the following criteria:

• Only companies identified as Buys by Zack’s
• Companies with the highest 5 year historical earnings growth rates (top 20% all Zack’s Buy Rec.)
• Lowest P/E ratio (bottom 20% all Zack’s Buy Rec.)
• Trading over $5 a share
• 10 day avg. share volume of 50,000 shares or more

As the AFG methodology has also proven effective in identifying attractive stocks regardless of their Growth or Value characteristics, we thought it would be interesting to check the valuation attractiveness of Mr Hoffman’s stocks via AFG’s Value Expectation application. AFG’s Value Expectation allows us to understand the imbedded Sales Growth, EBITDA Margins, and Asset Turnovers a company has to deliver in the future to justify its current trading price. In theory and in normal circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued. The following table displays the implied future sales growth of Mr Hoffman’s companies assuming their EBITDA margins and Asset turnovers stay at the 5 year median levels.

Companies recommended by Mr Hoffman appear to have pessimistic future sales growth implied by their current stock prices, when compared to their historical sales growth, and appear to be undervalued from AFG’s valuation perspective. Before making a wise investment decision, however, we also need to understand a company’s corporate performance (Economic Margin), management quality, competitive advantages and valuation attractiveness relative to its industry and sector peers. AFG’s institutional product helps investors to gain considerable insight regarding those aspects through its proprietary framework and we will provide a detailed tutorial of this process next week. 

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In Joel Greenblatt’s 2006 book, The Little Blue Book that Beats the Market, he presented his “Magic Formula” used in his hedge fund, Gotham Capital. Mr Greenblatt tested his formula between 1988 and 2004. The results were incredible, with only one down year, the magic portfolio would have returned 30.8% a year, against a 12.4% annual return for the S&P 500.

Mr. Greenblatt was a student of both Ben Graham and Warren Buffet and tried to include valuable insights from each investor in his “Magic Formula.” His Magic Formula was a screen that percentile ranked two variables: Return on Invested Capital (quality) and Earnings Yield (valuation). The idea is simple, buy the best companies at the best price. He also recommends one year holding periods, so we thought this would be a great time to get this list out. The Little Blue Book recommends selecting the top 30 firms from the “Magic Formula.” That formula ranks each company by variable and then puts a 50% weight on each. Below is a definition of each variable.

Variable 1: Return on Invested Capital = EBIT / (Net Working Capital + Net Fixed assets)

Variable 2: Earnings Yield = EBIT/EV

The table below shows the top 30 firms with their market implied sales growth expectations. Enjoy!

Economic Margin (EM) Defined - A measure of corporate performance that captures off balance sheet items, by looking at how much a company is earning above or below their cost of capital. EM is expressed in a % or margin. The 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.

Here is a list of companies, two from each sector within the S&P 500 that are expected to improve their Economic Margins (EM) the most over the next two years along with the bottom two in each sector expected to have their EM’s deteriorate the most. Companies expected to improve their EM’s more than their sector peers have proven to be more likely to out-perform. Improving EM’s coupled with low expectations priced-in for sales growth are the companies on this list that may be worth a look as a potential investment.

Also included in this table is the implied sales growth priced-in over the next five years in order to justify the stock’s current trading price compared with their achieved 5 Year Median Sales Growth. Ask the question are the expectations for sales growth realistic compared with what revenue growth the firm has delivered in the last five years.

If you would like to learn more about the Economic Margin methodology or Value Expectations feel free to contact an AFG representative to schedule a web-demo at support@afgltd.com.

S&P 500 Companies with the Biggest Forecasted Change in Economic Margins