In a previous column, I discussed a categorization scheme to help identify different types of companies based on the work of Bennett Stewart in his book The Quest for Value. Although the X, Y, Z scheme is not as well-known as Peter Lynch's six company types (fast growers, stalwarts, slow growers, cyclicals, turnarounds, and asset plays), it can play a valuable role in understanding a company's investment story.
The X, Y, Z categorization method is especially useful when trying to value fast-growing companies that generate negative free cash flow. These are Z companies, and trucking company Knight Transportation (NYSE: KNX ) is a perfect example of one.
Knight creates value in two ways. First and foremost, the company maintains economic profits, which over the past five years has averaged almost 16% -- 4% over its cost of capital. Because Knight creates value with its operations, any growth in its invested capital will create even more value, and that's the second way the trucking company creates value.
Since the end of fiscal 2000, Knight's invested capital has grown at a compound annual growth rate of 17.7%. This is even more special, because Knight didn't have to use much external financing. The company used the cash from deferring income taxes for capital expenditures.
The result of all of this value creation is that Knight trades at three times its invested capital -- $1.48 billion in enterprise value compared with $487 million in invested capital. Whoa -- three times? Even a Z company's ability to create value has its limits. If Knight maintains a return on invested capital of 16% and grows its invested capital by 20% over the next several years, the company is not worth more than $15 per share. At the current price of $17.44, Knight may very well see its valuation come down.
Look at it another way: To warrant Knight's current valuation, in 10 years, the trucking company must be able to invest another $2 billion into its business. However, as smaller companies -- such as Knight itself and Heartland (Nasdaq: HTLD ) -- increase competition with the likes of YRC Worldwide (Nasdaq: YRCW ) and JB Hunt (Nasdaq: JBHT ) , they will begin bumping fenders for more business, and Knight's future growth could become significantly curtailed. And lower growth expectations will always put the brakes on a company's valuation.
The best time to invest in a Z company like Knight is when there are no expectations for future value creation. The closest Knight came to that situation was during the last recession, when the share price fell below $4. A Fool spotting this opportunity would have hauled in some of his or her own value creation.
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