Cash Flow Analysis

[DJG]

Check out the operating leverage (working capital), especially deferred revenue. They use their students' money (at no cost) to fund the business.

Similar to how Buffett uses the insurance float and reinvests/allocates it around.

 

[galumay]

Check out the operating leverage (working capital), especially deferred revenue. They use their students' money (at no cost) to fund the business.

Doh! See thats the problem, now you have told me where to look I can find the easter eggs!

I guess its just time and effort to learn to spot these anomolies and then understand what they mean.

Thanks for sharing, mate.

 

[luutzu]

I'm a little confused by your post, but the table you've provided does show the point I was making...

retained earnings * RoE (ROIC is superior) = sustainable growth rate.

In 1982: 72% * 18.73% = 13.49%

I think you're confusing growth rate with RoE. Of course if incremental ROE (ROIC) is higher than historical ROIC then you'll get a theoretical growth rate that is higher than what the balance sheet would suggest.

Also, in terms of FCF this won't work in the case of NVT because it won't capture the fact they can grow while paying out everything.

The formula works out, but I don't get it. So in 1982, actual ROE (growth) is 18.73%, Walgreen retained 72%, so its sustainable growth is 13.49%. This mean the 18.73% growth is not typical, or was the case but the future sustainable rate is 13.49% or thereabouts.

In other words, if the logic of this formula works in ways I think it is meant to work... Walgreen's ROE should be around the sustainable rate indicated a year or so previously - grow at 13 - 15% or so. However, as that table also indicate, its ROE is consistently higher, i.e. sustainable, at a higher rate than the formula indicate.

So the limit of growth as measured by ROE doesn't work. Might work if define growth to mean the size of the equity, not the profit/return on equity.

 

[McLovin]

So in 1982, actual ROE (growth) is 18.73%,

ROE <> growth!

If you have $100 (equity) in your bank account and it earns a fixed 10% interest (roe) and you take the $10 and spend it, then in year two you will still be earing the same return (10%) but there will have been no growth in $$ earnings because you withdrew it and spent it. If you left it in the account then in year two you would earn 10% on $110, ie $11...and so on. It's the same for a company...compounding isn't a free lunch. Otherwise you have situation of ROE increasing to infinity.

The table is basic maths. Column A * Column B = Column C.

And once again...ROE is not growth.

 

[luutzu]

ROE <> growth!

If you have $100 (equity) in your bank account and it earns a fixed 10% interest (roe) and you take the $10 and spend it, then in year two you will still be earing the same return (10%) but there will have been no growth in $$ earnings because you withdrew it and spent it. If you left it in the account then in year two you would earn 10% on $110, ie $11...and so on. It's the same for a company...compounding isn't a free lunch. Otherwise you have situation of ROE increasing to infinity.

Yea, that's what I thought the formula might indicate - the cash account gets bigger, but rate of growth is the same (not affected) by retained earnings.

But that's not really growth as the name suggests. When I first heard I thought it's a neat way to work out a company's growth potential, as in its profitability. But what use is it to know the the more it retain its earnings, the bigger it gets... maybe some use, but misleading to call its the company's sustainable growth rate.

 

[VSntchr]

There's a reason I automate these stuff, so no need to think, haha.

I know the feeling, sorry for the probing and making you think :

So a normal business that's losing money but spend too much in its "investing" cash outflows, mostly funded from incoming financing activities... i stay away from. A good example is Transpacific. Kept losing money but expand like crazy, it didn't end well.
.

Another good point. Something that I have been looking into recently; companies which utilise the ability to invest via the PnL as much as possible. Short term it's not as pretty for earnings, but it saves on the tax bill and avoids bloating balance sheet and risk of write-downs. Shows good long-term focused management.

 

[KnowThePast]

I know the feeling, sorry for the probing and making you think :


Another good point. Something that I have been looking into recently; companies which utilise the ability to invest via the PnL as much as possible. Short term it's not as pretty for earnings, but it saves on the tax bill and avoids bloating balance sheet and risk of write-downs. Shows good long-term focused management.

This is very interesting.

Could you think of any automated measures that could screen for these kind of companies?

Current ratio is probably a start, but that will show distressed companies, as well as those that genuinly can run a negative working capital.

I would be curious to run a backtest on it and I'd be happy to share the result.

 

[McLovin]

But that's not really growth as the name suggests. When I first heard I thought it's a neat way to work out a company's growth potential, as in its profitability. But what use is it to know the the more it retain its earnings, the bigger it gets... maybe some use, but misleading to call its the company's sustainable growth rate.

It's really difficult to have a discussion with you because you seem to use the terms growth and profitability interchangeably.

In any event, it does more than tell you that if you retain your earnings you'll get bigger, it shows what sort of growth you can generate from a given reinvestment into the business. A company with an ROE of 50% can grow at the same rate as a company with an ROE of 5% but use 1/10th the money. That's a pretty simple relationship but one that plenty of people overlook. It's sustainable in the sense that its unlikely that a company could produce a higher growth rate for a sustained period of time because of things like asset utilisation etc.

 

[McLovin]

This is very interesting.

Could you think of any automated measures that could screen for these kind of companies?

Current ratio is probably a start, but that will show distressed companies, as well as those that genuinly can run a negative working capital.

I would be curious to run a backtest on it and I'd be happy to share the result.

Negative wc needs to be viewed in the context of the business and the balance sheet. WOW has negative working capital (which is pretty common for supermarkets) but doesn't have the same advantage that NVT does because WOW makes large investment into PP&E. NVT funds its business from student fees received in advance. I don't think isolating for WC will offer up much, but I'd be interested to see the results. Maybe look at negative WC and high ROIC, but then you could question whether any superior performance is derived from the higher ROIC rather than the WC.

I guess the overarching idea I'm trying to convey, especially as it relates to FCF, is to look at how much growth costs. WOW could never grow at the speed that MFG has, because MFG can expand exponentially by adding a few a desks and computers.

 

[KnowThePast]

Negative wc needs to be viewed in the context of the business and the balance sheet. WOW has negative working capital (which is pretty common for supermarkets) but doesn't have the same advantage that NVT does because WOW makes large investment into PP&E. NVT funds its business from student fees received in advance. I don't think isolating for WC will offer up much, but I'd be interested to see the results. Maybe look at negative WC and high ROIC, but then you could question whether any superior performance is derived from the higher ROIC rather than the WC.

I guess the overarching idea I'm trying to convey, especially as it relates to FCF, is to look at how much growth costs. WOW could never grow at the speed that MFG has, because MFG can expand exponentially by adding a few a desks and computers.

Perfectly right.

What I am trying to do is to bring a statistical proof that this perfectly logical theory works. But that can only be done if the picking of, let's call them, free growth companies can be automated.

Backtesting just on current ratio does not give terribly useful results, although it buying 25 companies with lowest current ratio and rebalancing yearly does beat the index by a small margin.

And so, some combination of filters would be needed. So, to rephrase my question - are there financial measures that help identify this free growth - or is it something that can only be identified by using your judgement?

 

[Klogg]

I don't think isolating for WC will offer up much, but I'd be interested to see the results. Maybe look at negative WC and high ROIC, but then you could question whether any superior performance is derived from the higher ROIC rather than the WC.

Aren't you essentially looking for a capex light business (resulting in high ROIC) that allows prepayments? If that's the case, a low NTA to share price (you could use BV, but acquisitions/goodwill would throw you out) combined with a search for negative WC should give the desired result.
That said, any heavily indebted company that's had a good year would appear in this result (e.g. FMG last year) so there's still probably too much noise in that set of filters.


On another note, CTE and NEA are smaller businesses that lend themselves to prepayments, so if the aim is to understand the impact of prepayments alone on the balance sheet, check those two out.
What they don't do is leverage that cash flow (CTE has over 6m cash holding for 4m in unearned income), so the neg WC model isn't on display.

 

[KnowThePast]

Aren't you essentially looking for a capex light business (resulting in high ROIC) that allows prepayments? If that's the case, a low NTA to share price (you could use BV, but acquisitions/goodwill would throw you out) combined with a search for negative WC should give the desired result.
That said, any heavily indebted company that's had a good year would appear in this result (e.g. FMG last year) so there's still probably too much noise in that set of filters.


On another note, CTE and NEA are smaller businesses that lend themselves to prepayments, so if the aim is to understand the impact of prepayments alone on the balance sheet, check those two out.
What they don't do is leverage that cash flow (CTE has over 6m cash holding for 4m in unearned income), so the neg WC model isn't on display.

Thanks Klogg,

Gave that a shot, you were right, too much noise from crappier companies. (and not a great result either).

It doesn't always have to be low capex, I think. CKF is an example of a fairly high capex business, that successfully uses a negative working cap setup.

 

[McLovin]

Aren't you essentially looking for a capex light business (resulting in high ROIC) that allows prepayments? If that's the case, a low NTA to share price (you could use BV, but acquisitions/goodwill would throw you out) combined with a search for negative WC should give the desired result.
That said, any heavily indebted company that's had a good year would appear in this result (e.g. FMG last year) so there's still probably too much noise in that set of filters.

I thought about that, but that will throw up a lot of growth by acquisition companies. So if you're automating the process how do you avoid false positives unless you somehow screen for indefinite life intangibles? Otherwise you could go around paying peanuts for low growth assets and then have them revalued as growth assets by the market once you acquire them...oh wait...

I think if you, generally, stick to companies with low fixed asset investment though you're playing in the right ball park.

 

[galumay]

Can anyone help me understand IMF's cash flow and why it looks so poor? If you remove the share issue and bond issue it looks very sick indeed! Am I missing something which makes it ok?

 

[skc]

Can anyone help me understand IMF's cash flow and why it looks so poor? If you remove the share issue and bond issue it looks very sick indeed! Am I missing something which makes it ok?

Cashflow statements concern with cashflow over a specific accounting period. For IMF, accounting periods mean little to their case work because of the long lead time - it could be 5+ years from starting a case to actually banking the settlement fees (e.g. the bank fees class action). So looking at cashflow for IMF over any single period is not particularly insightful. You will need to analyse it over say last 10 year and see how much capitalised "case investment" were realised in the form of settlement fees, and project that forward the best you could.

And just to confuse the issue a bit more, they changed their accounting terms some time around 2010... they turned "case investment" from operating cashflow to investing cashflow. The actual implication is neither here nor there, but it means that you need to grab the numbers from under the different headings.

 

[galumay]

...
And just to confuse the issue a bit more, they changed their accounting terms some time around 2010... they turned "case investment" from operating cashflow to investing cashflow. The actual implication is neither here nor there, but it means that you need to grab the numbers from under the different headings.

Thanks SKC, i picked that change up, and it certainly looks odd, having it accounted for in investing cashflow. I guess I am just too inexperienced to know how to make sense of what is a history of negative cash flows by standard accounting practice, so it leaves me with a level of uncertainty that is uncomfortable. On the other metrics I am inclined to buy at the current price, but my inabilty to find a level of comfort with the cashflow makes me stand back.

 

[skc]

Thanks SKC, i picked that change up, and it certainly looks odd, having it accounted for in investing cashflow. I guess I am just too inexperienced to know how to make sense of what is a history of negative cash flows by standard accounting practice, so it leaves me with a level of uncertainty that is uncomfortable. On the other metrics I am inclined to buy at the current price, but my inabilty to find a level of comfort with the cashflow makes me stand back.

The cashflow analysis needs to take into account that they are building larger and larger case portfolios. So this growth costs capital and further complicates the picture.

Think of IMF as the polar opposite of NVT in terms of cash flow and how that funds growth. With NVT you have tens of thousands of students prepaying their tuition fees for NVT to invest as it sees fit. With IMF you have tens of thousands of hours of lawyer fees being paid by IMF first, often over long periods of time, before the investors (hopefully) see a return. Thus I am not a huge fan of this model.