Michael K. Ozanian, Forbes Magazine, 04.20.98
SAY "BLUE CHIP" and you probably think about the level or the growth rate of a company's earnings. On those scores, the big outfits that appear on one or more of the Forbes 500 lists are doing fine. Their combined earnings of $357 billion last year came to 6.3% of revenues and were up 7% over the year before.
Earnings growth is good, but it's not enough. Earnings quality matters, too. What do we mean by quality? Imagine two companies, each netting $100 million on sales of $1 billion. Company A banks the $100 million. Company B plows back every penny into operating assets -- factories, equipment and inventory. Over time, for all its furious investment, however, B displays no growth in revenue or net income. In its profitmaking and reinvesting it is just treading water.
Company B has an earnings quality problem. Investors who focus on earnings per share may love the company at first, but sooner or later they are going to wake up to the fact that they can't take those earnings to the grocery store. If B pays a dividend, it is either depleting a bank account or borrowing money in order to do so. Someday the money is going to run out. This could happen even as the reported earnings continue to gush in.
Alas, no companies have financial pictures as clear as those of Company A and Company B. In the real world, you can readily ascertain how much cash flow a company generates (in the sense of earnings plus depreciation), and you can get its capital expenditure figure, and you can compare the two. But what you don't know is how much of the capital expenditure went for genuine expansion and how much did nothing more than allow the company to maintain its existing activities.
Intel makes a mint, but also spends a lot on new chip factories. How much of those outlays merely enable Intel to run in place? You really don't know, unless you know a lot about the computer business.
Still, investors must do the best they can to detect which companies are generating spendable cash -- and which are not. For this purpose one of the more intriguing formulas we have seen comes from Ernst Institutional Research, a Boston boutique that sells quality-of-earnings analyses to Fidelity Investments, Colonial Funds and others. The original author of the Ernst formula is Harry B. Ernst, a Harvard-trained economist and a former professor of accounting who developed the Federal Reserve Board's model for its industrial production index.
Ernst's formula starts by comparing a company's growth in net worth over the course of a year to its growth in operating assets (basically:plant, equipment, inventory). You subtract the latter from the former.
The result is a crude measure of the outfit's free cash flow. Putting aside for a moment the possibility that a dividend has been paid, the difference in these two numbers represents the amount of cash that has piled up from the business. Say Company C earns $100 million, generates $80 million from depreciation charges, pays no dividend and spends $150 million of its cash flow on a new fleet of trucks. The growth in the company's net worth in this example is $100 million; the growth in the business assets is $70 million ($150 million of new trucks minus $80 million of wear and tear). Subtract $70 million from $100 million and you get $30 million -- the cash that has piled up from the business.
For simplicity, we have ignored working capital fluctuations from receivables, payables and the like. Let's move on to the third important element in the Ernst formula. Take the $30 million figure and subtract the growth in liabilities. This is a somewhat arbitrary part of the formula, aimed at penalizing outfits with deteriorating balance sheets.
In our hypothetical example there is no change in liabilities.
Last step: Divide the $30 million by sales to get a percentage figure. If C's sales for the year were $1 billion, you'd have a 3% ratio. The point of this step is to allow for the fact that a company with growing sales probably can't avoid expanding its business assets at the same pace -- but also should be keeping up the pace in retained earnings.
Okay, Company C has a 3% ratio. Now what? By itself, explains Jeffrey Fotta, a managing director in the Ernst firm, this is a meaningless figure. What he looks for is an upward or downward trend in the ratio over a period of ten years. A rising ratio, he says, is likely to be found in a company whose earnings are more than keeping pace with its growth in revenue and capital expenditures. A company with a declining ratio may be destined to go into hock to pay its bills.
You'll notice some quirks in the Ernst formula. A company's ratio in any one quarter would be forced down by an outsized dividend increase -- even though most investors would not rate a dividend increase as a bad thing. Also, the formula double-penalizes companies for debt-financed expansions: once in increased business assets and again in increased liabilities.
But this would not lower a company's rating unless the assets proved unproductive, because the formula measures trends over such a long period of time. Last summer the Ernst formula flagged Oxford Health for a declining cash ratio trend over several quarters -- at a time when Oxford was reporting terrific earnings. To be sure, Ernst had no idea what was really going on, which was that Oxford was understating what it owed to doctors, and thus overstating its earnings. But the formula perhaps picked up some financial rumblings before the earthquake. The stock lost two-thirds of its value in October when the problem with the payables came out.
One way to use Ernst's formula is to compare a company's cash flow trend to its valuation. General Electric and Microsoft have excellent cash flow trends, according to Ernst. But they sport 1998 estimated price/earnings ratios of 28 and 50, respectively, against a median of 19 for the Forbes 500s. So their strong fundamentals are already reflected in their stock prices. Hercules Inc. and Eastman Kodak have declining cash flow trends. But their deteriorating balance sheets are already reflected in their multiples, which are both 15.
The trick is to find companies with improving cash flow trends and reasonable prices. The table at the far left shows ten Forbes 500s companies with both very positive cash flow trends and estimated P/Es below 18. The other table lists ten companies with deteriorating cash flow trends as well as estimated 1998 P/Es of 21 or higher. We'll revisit these lists next year.