Wednesday, April 01, 1998
ALEXANDRIA, VA (Apr. 1, 1998) -- One of the hovering questions about the Cash-King Portfolio is why we don't employ more rigorous valuation work when picking our stocks. It almost looks like we're willing to buy big, familiar-name companies at any price. At present, we're holding shares of Microsoft at 60x earnings, shares of Coca-Cola at 47x earnings, and shares of Pfizer at 55x earnings. On the surface it appears that your Foolish Cash-King managers have lost their minds and aren't concerned with value, only with growth.
I've been struggling now for a few months, trying to figure the best way to articulate that we are concerned with values and valuation. We do believe the underlying long-term value of a business is a key consideration for investors. But what we do resist is talk of valuation in CK-dom with a focus on traditional forms of measurement. We don't think the traditional methods used to value public companies much work with businesses like Microsoft and Coca-Cola.
After all, a strict adherence to the price-to-earnings (P/E) ratio, or our Foolish PEG ratio, or even our YPEG ratio for larger companies, would have had you not buying either Coca-Cola or Microsoft over the past decade. During that time, the two have fast and far outgrown the broader market. Microsoft is up more than 90x in value; Coca-Cola is up more than 15x in value.
In fact, the more popular, traditional valuation tools haven't worked on Coca-Cola (NYSE: KO) for seven decades -- and it's pretty much been the slam-dunk greatest investment in the U.S. in the 20th century. One of two things is happening here. 1) Either the market is horribly, horribly inefficient in its assessment of the value of the Coca-Cola Company, or 2) the valuation mold that may fit smaller companies doesn't work for our monopolist of a soft industry like soda syrup. The P/E ratio and its general applications don't work for Coca-Cola.
If that's the case, then do we just throw our hands up in the air and buy or sell the stock on a whim? Well, we promise not to.
To get closer to an understanding of what we mean by value and valuation in the Cash-King portfolio, permit me leave to return to the Foolish Flow Ratio, outlined in Step #7 of the 11 Steps to Cash-King Investing. In qualitative terms, the Flow Ratio offers a contrary take on the current assets entries (absent cash), proposing that they're an unattractive part of the business. Who wants a business to have high inventories? Who wants a high level of uncollected bills (receivables)? Those items are both listed under current "assets" -- a misnomer, we believe.
Why? Because the best businesses turn their inventory over extremely quickly -- the product is made and delivered, post haste. And the best businesses are also able to demand upfront payments from their distributors -- when they sell Tickle-Me-Elmo dolls to toy stores they can demand upfront payment from the stores. The end result of these is a business that is constantly turning product into cash -- cash that it can reinvest in its business, pronto.
The problem with our beloved Flow Ratio -- and since it's still pretty much an infant, we have trouble being too critical of it right yet -- is that it isn't reflected on the income statement. The Flow Ratio deals strictly with balance sheet items. In the meantime, much of the educational focus for investors is on the income statement (What's the company's sales growth? How much money does the company make from its sales?). And Wall Street is obsessed with whether a company has beaten, met, or undershot its quarterly earnings estimates -- again, reflected on the income statement.
What comes of all that? Many investors end up focusing intensely on that P/E ratio. In doing so, they're looking at the price of the company's stock and they're studying the earnings per share announced by the company. But what they aren't doing, when they stick to the P/E ratio, is assessing the quality of those earnings. After all, if two companies have identical earnings growth rates, but one of them collects all of its bills upfront and the other can't collect them for 180 days, there is a different value to those earnings. Likewise, if two companies have identical income statements, but one carries inventory on average for six months and the other for six weeks, the merit of the companies' growth differs.
These differences don't show up when we look at the P/E ratio and the company's projected annual growth rate. Thus, our affection for the Flow (nicknamed "Flowie").
All else being equal, of the two companies above, we'd be more interested in the one carrying less inventory and the one collecting its bills upfront (lower receivables). Unfortunately, again, these items aren't registered on the income statement and thus have no immediate effect on a company's P/E ratio. So you end up with two companies trading at 25x earnings. They may even have identical earnings projections for the next five years, but we believe you're looking at different businesses, the quality of whose earnings could differ substantially.
In essence what I'm saying is that the Flow Ratio acts as a sort of valuation tool for us. But even then, it doesn't nail down the mythical "fair price" for anyone. And it seems to strike some investors as removed from the real game in the marketplace -- the game of where the stock price belongs today based on its near-term earnings picture. The answer to that tells many whether to buy, buy more, to sell all, or sell some. In an effort to slide us a bit closer toward that, mostly to make a point about valuation, I'd like to offer up a logical but very, VERY informal calculation that does move the force of the Flow Ratio onto the income statement. I'll offer it in mathematical form first, then review it below.
Be forewarned: Calculations always look scary at first blush.
Earnings - [(Receivables x 0.25) + (Inventory x 0.50)] = Pure Earnings
What we're doing here is reducing the total amount of earnings a bit to arrive at a purer reflection of the company's earnings. The business with no inventory and all bills collected will have a P/E ratio that isn't affected by our little calculation. Contrarily, the business with a heavy load of inventory and trouble with its collections will see a fairly dramatic change in its pure earnings, and thus in its price-to-earnings ratio. Is that clear? If not, drop by our message folder (Cash-King Board); I'd be more than happy to answer questions about this.
To restate this one more time, we're trying to find a way to punish companies for carrying inventory and/or for announcing significant amounts of sales that they haven't yet collected. Another way to approach it is that we're trying to reward businesses that carry very little inventory and that get paid upfront (or very quickly) for selling their wares.
You might not be surprised to hear that the companies whose P/E ratios are largely unaffected by this calculation are the Cash-Kings -- particularly Microsoft and Coca-Cola. Other, we think lesser, businesses are going to be affected rather dramatically. Whether it's Nike being forced to wait for payments for its shoes around the world or Kmart carrying billions of dollars in inventory, until we begin interrupting the earnings statements with some assessment of the value of those earnings, we are not going to see potential troubles on the horizon.
For now, let's leave it at that. That's enough math and philosophy for one evening. On Friday, I'll return to this report and provide a slew of sample calculations. But tomorrow, I'd like to provide some suggestions for Coca-Cola that I think could prove useful. (Oh, man, that sounds so arrogant. A Fool help Coca-Cola? Well, we're owners of the company and consumers of its products. Where else should ideas come from?!).
Fool on and enjoy this magical day!
Day Month Year History C-K +0.80% 0.80% 4.78% 4.78% S&P: +0.58% 0.58% 10.67% 10.67% NASDAQ: +0.65% 0.65% 11.78% 11.78% Rec'd # Security In At Now Change 2/3/98 22 Pfizer 82.30 98.69 19.91% 2/27/98 27 Coca-Cola 69.11 80.63 16.67% 2/3/98 24 Microsoft 78.27 90.38 15.47% 3/12/98 20 Exxon 64.34 68.94 7.15% 2/6/98 28 T. Rowe Pr 67.35 71.00 5.43% 3/12/98 20 Eastman Ko 63.15 65.88 4.32% 3/12/98 15 Chevron 83.34 82.50 -1.01% 3/12/98 17 General Mo 72.41 67.38 -6.95% 2/13/98 22 Intel 84.67 77.50 -8.47% Rec'd # Security In At Value Change 2/3/98 22 Pfizer 1810.58 2171.13 $360.55 2/27/98 27 Coca-Cola 1865.89 2176.88 $310.99 2/3/98 24 Microsoft 1878.45 2169.00 $290.55 2/6/98 28 T. Rowe Pr 1885.70 1988.00 $102.30 3/12/98 20 Exxon 1286.70 1378.75 $92.05 3/12/98 20 Eastman Ko 1262.95 1317.50 $54.55 3/12/98 15 Chevron 1250.14 1237.50 -$12.64 3/12/98 17 General Mo 1230.89 1145.38 -$85.52 2/13/98 22 Intel 1862.83 1705.00 -$157.83 CASH $5666.26 TOTAL $20955.39 *The year for the S&P and Nasdaq will be as of 02/03/98