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 particularly valuable because it is grounded in the assets that produce the company's profits. Projected future cash flows can often become unmoored, and using an alternative method to triangulate a company's value is just plain Foolish.
For an example, let's look at an unmistakable Y company, AutoZone (NYSE:AZO). Remember, a Y company earns high returns on its invested capital (ROIC) but is unable to invest much of the profits back into the business.
AutoZone, because of its size and quality management team, earns superior margins in a competitive, cyclical, and seasonal industry. And it has done so despite a large number of competitors, including Advance Auto Parts (NYSE:AAP), O'Reilley Automotive (NASDAQ:ORLY), and Pep Boys (NYSE:PEP), as well as big-box retailer Wal-Mart (NYSE:WMT).
Although the company is highly profitable, the intense competition is making it hard for AutoZone to materially expand its business. The 2%-4% growth in the company's invested capital over the past six years confirms AutoZone's lackluster growth. No matter how strong the company's ROIC, if AutoZone isn't able to expand its operating base, it can't create value.
If AutoZone manages to grow its invested capital at 4% and maintains its 20.3% ROIC, I still would be hesitant to pay more than $100. At $116 per share, AutoZone's current $4.8 billion in premium over its invested capital signals to this Fool that the business is at best fairly valued, if not overvalued.
Part of the premium is justified based on the company's high ROIC, but can the growth make up the rest? AutoZone would be worth less than $70 per share if it maintained its profitability but didn't grow its invested capital. Grounding a company's investment story based not only on cash flows but also on operating assets can help signal when an opportunity presents itself, as AutoZone did in 2003, and when it makes less sense -- which is the case today.
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AutoZone and Wal-Mart are both Inside Value recommendations. To find out how Philip Durell is leading the newsletter service to market-beating returns, try it out free for 30 days .
Fool contributor Matthew Crews welcomes your feedback -- really! He has no financial position in any of the companies mentioned. The Motley Fool has a disclosure policy .
