2 Kinds of Cheap: Margin of Safety vs. Annual Return
A stock can be cheap in two ways:
- It can have a highmargin of safety.
- It can promise a highannual return.
A stock like Weight Watchers (WTW) promises a high annual return. Here is Weight Watcher’s past 11 years of free cash flow data presented as a percentage (yield) of its current market cap ($2.05 billion).
Minimum: 10.3% (2008)
Maximum: 17.4% (2011)
Median: 12.4% (2004)
Mean: 12.8%
Standard Deviation: 2.0%
Variation: 0.16
From a leveraged free cash flow perspective, if 2004 was a normal year for Weight Watchers the stock’s earning power is 12.4% of today’s price. If 2008 was a normal year, the stock’s earning power is 10.3% of today’s price. If 2011 was a normal year, the stock’s earning power is 17.4% of today’s price.
To avoid permanent impairment, a stock’s earning power should be at least 6.67%. This is because stocks often trade at 15 times earnings and 1 divided by 15 is 6.67%. So a 6.67% free cash flow yield is sufficient to support a stock price.
If a stock’s price declines while it persists in delivering 7% or more of your purchase price in free cash flow each year, it’s appropriate to consider your loss a purely “paper loss”. If your intention is to hold the stock indefinitely, you may never need to realize that loss.
Ben Graham defined safety as:
Protection against loss under all normal or reasonably likely conditions or variations.
Since a 7% free cash flow yield is an adequate protection against loss, we can substitute that number for Graham’s phrase “protection against loss”.
We can then define a stock’s safety as its:
Likelihood of delivering annual free cash flow of 7% or more of your purchase price under all normal or reasonably likely conditions or variations.
Leveraged numbers – like free cash flow yield (free cash flow/market cap) – show you annual return possibilities. They do not provide any hints about margin of safety.
Capitalization independent numbers do.
A stock like Weight Watchers does not provide a high (quantitative) margin of safety. Here is Weight Watcher’s past 11 years of EBITDA data presented as a percentage (yield) of its current enterprise value ($4.34 billion).
Minimum: 7.3% (2004)
Maximum: 13.3% (2011)
Median: 9.1% (2006)
Mean: 9.3%
Standard Deviation: 1.8%
Variation: 0.20
EBITDA is cash flow the company has available to make capital expenditures, pay interest, pay taxes, make debt repayments, and finally – only after these other things have been done – buy back stock and pay dividends to shareholders.
If 2004 was a normal year for Weight Watchers, the company’s EBITDA power is only 7.3% of today’s enterprise value. This EBITDA is what protects both the creditors and owners of the company from impairment. A 7.3% EBITDA/EV yield is low. It’s equivalent to an EV/EBITDA ratio of 13.7x. That’s unsustainable. So someone – like me – who owns Weight Watchers stocks must believe that the company’s future EBITDA will not be as low as it was 10 years ago.
The stability of EBITDA can be analyzed quantitatively and qualitatively.
Quantitatively, we can say that over the last 11 years Weight Watchers’s EBITDA has a standard deviation of $80 million (which is 1.8% of today’s enterprise value). Its minimum EBITDA – recorded in 2004 – was $316 million (which is 7.3% of today’s enterprise value). Recently, EBITDA has averaged about $560 million (which is 12.9% of today’s enterprise value). For those accustomed to multiples rather than yields – that’s an EV/EBITDA ratio of 7.8.
The stability of EBITDA can also be analyzed qualitatively. How much of revenue comes from retained customers (the average person stays with the program for about 9 months)? How much of revenue comes from returning customers (those who quit Weight Watchers and later rejoin)? How much of revenue comes from word of mouth referrals? How much of revenue comes from unrefered new business wins? How stable is demand for weight loss through different economic conditions (cyclical)? How stable is demand for weight loss through history (secular)? How durable is Weight Watchers customer goodwill (mindshare)?
The sufficiency and stability of EBITDA – considered both quantitatively and qualitatively – relative to enterprise value is what determines your margin of safety.
Free cash flow yield (free cash flow / market cap) may provide information about possible returns. It doesn’t provide information about your margin of safety.
That means there are two different kinds of cheapness. A stock can be cheap on a Market Cap / FCF basis and not cheap on an EV/EBITDA basis.
Weight Watchers’s 3-year average free cash flow is $296 million. The market cap is $2.05 billion. That gives it a price of 6.9 times free cash flow. Which is very cheap.
Weight Watchers’s 3-year average EBITDA is $565 million. The enterprise value is $4.34 billion. That gives an EV/EBITDA of 7.7 times. Which is normal.
If I had to use one measure, I’d always pick EV/EBITDA over price to free cash flow. But that’s only because if I had to choose between having a margin of safety and a high annual return – I’d choose the margin of safety.
Of course, it’s a manufactured dilemma. You can simply check your stocks against both criteria:
- Is there an adequate margin of safety?
- Does the stock promise a high enough annual return?
For another perspective on WTW see “A Closer Look at Weight Watchers”.