Blog – Page 86 – Focused Compounding

Geoff Gannon March 1, 2006

On Pre-Tax Return on Non-Cash Assets

This post was prompted by a comment to yesterday’s post on Sherwin-Williams.

PTRONCA = Earnings Before Taxes / (Total Assets – Cash & Equivalents)

Pre-tax return on non-cash assets is intended to eliminate any need for human judgment.

I understand why you might want to adjust for other assets, but you must not do this in calculating PTRONCA. I only intend the pre-tax return on non-cash assets as a quick first measure of profitability. There is no human judgment involved – that’s the idea. You can calculate PTRONCA in seconds and repeat the process over scores of businesses.

Obviously, there’s a lot you could adjust. You mentioned goodwill; there’s also excess working capital, marketable securities that you may believe are not really “available for sale” even though they may be so classified, etc.

The idea behind PTRONCA is to quickly measure the profitability of the business operations of both public and private companies. I think after-tax measures are not meaningful for most companies; because, except for the very largest American businesses, public companies can be taken private, financed with debt or equity, merged with other companies, move their HQs overseas, etc. Furthermore, companies like Journal Communications (JRN) could be broken up.

The pre-tax return on non-cash assets is often less variable for similarly profitable companies than the various profitability margins (e.g., net income / sales or FCF / sales). PTRONCA is very useful when there are differences in gross margins.

For instance, Village Supermarket (VLGEA) is an unusually profitable grocer that appears on the basis of its profit margin to be less profitable than many other grocers. Fixed costs and sales volume are important considerations in the groceries business. Obviously, you could look at sales per square foot and other industry specific measures, but I believe that’s more appropriate as a second step. It isn’t something you want to do until you’re starting to learn about the economics of the industry.

PTRONCA is not very useful if you already know something about the company or the industry. I agree sales are often more important. I’ve often cited sales numbers such as price/sales and the FCF margin. Both are essentially ways of valuing companies based on the belief that current sales are largely sustainable and a certain (minimum) normalized free cash flow margin is expected. For instance, with Overstock (OSTK), I was simply valuing a money losing business on the basis of expected free cash flow. That’s why sales numbers can be very important. If you’re convinced they can be sustained, or will grow at some minimum rate, you can even value loss–making businesses once you address the solvency issue.

Finally, the pre-tax return on non-cash assets obviously doesn’t consider the premium an investor is paying over the book value of the assets. It’s not intended to. Think of it like you would the return on capital half of Joel Greenblatt’s “magic formula”, it only provides part of the picture. You need to …

Geoff Gannon February 27, 2006

On Sherwin-Williams’ Profitabilit

Sherwin Williams (SHW) scores well on just about every profitability measure. Some companies I’ve mentioned in the past are more profitable than Sherwin-Williams. For instance, Timberland (TBL) scores much higher than SHW on just about every measure of profitability. The clearest difference between the two businesses is their pre-tax returns on non-cash assets (PTRONCA).

This is one of my favorite profitability measures. For the last five years, Timberland has consistently had a PTRONCA of 35 – 55%; Sherwin-Williams’ PTRONCA has been in the 12 – 16% range. This post isn’t intended to be a comparison between Timberland and Sherwin-Williams. I wanted to introduce you to my preferred method of calculating return on assets, and Timberland is the obvious choice for a PTRONCA comparison. Very few businesses earn a pre-tax return on non-cash assets greater than 25%.

The easiest way to earn a very high pre-tax return on non-cash assets is to have very few tangible assets. Businesses with very high PTRONCAs can grow without retaining earnings. Generally, maintenance cap ex is minimal, and little investment is required beyond additions to working capital.

Sherwin-Williams’ pre-tax return on non-cash assets of 12-16% is very good. The company has not kept much cash on hand during the last few years, so SHW’s PTRONCA of 12-16% translates almost perfectly into the expected (traditional) ROA of 7.2 – 9.6%. I say “expected”, because a pre-tax ROA of 12-16% translates into an after-tax ROA of 7.2-9.6% at an effective tax rate of 40%.

In other words, my adjustments to the return on assets computation make little difference in this case. It’s clear Sherwin-Williams consistently earns an above average return on assets whether you use the traditional ROA measure or the pre-tax measure with the cash adjustment.

Sherwin-Williams’ has consistently earned a good return on equity while employing little debt. Over the last ten years, the company’s ROE has usually been in the 15-25% range. Sherwin-Williams has regularly bought back stock. The number of shares outstanding is about 20% less than it was a decade ago. Share repurchases and dividend payments have helped Sherwin-Williams increase its ROE year after year. For several years, the company’s ROE has been following a clear upward trend.

Sherwin-Williams has also been putting retained earnings to good use. Obviously, there is a correlation between a company’s return on retained earnings and its return on equity, because retained earnings increase shareholder’s equity. Looking at the amount of retained earnings in relation to EPS growth over various time periods can sometimes provide clues regarding the relationship between a company’s return on capital and its return on incremental capital. Sherwin-Williams’ returns on retained earnings match the company’s returns on equity very closely. Both the range (15-25%) and the trend (upward) of SHW’s return on retained earnings serve to confirm the company’s return on equity data.

Finally, as Rick of Value Discipline noted, Sherwin-Williams has regularly increased its dividend. I believe this year will be the 27th consecutive year in which the …

Geoff Gannon February 26, 2006

Value Investing Directory: New Additions

The Value Investing Directory has a new navigation structure. The “Navigate Directory” section will remain at the top of your screen after you pick a new category. To navigate the directory, simply click on a category and then scroll down to see the listings within that category.

After you click on a category, the “category tree” will remain at the top of your screen; however, the listings below will change. Therefore, you need to remember two things: 1) Scroll down to see the listings 2) Choose “deeper” sub-categories to refine your search. For example, there are fewer listings in Blogs > Investing Blogs > Value Investing Blogs than there are in Blogs > Investing Blogs, because all value investing blogs are also listed as investing blogs.

The directory now includes 17 new listings. First, let me discuss the submission process. Then, you can view the list of new additions.

Submissions

To submit a site for inclusion in the Value Investing Directory please send an email to [email protected] with the site’s URL. All submissions will be evaluated within 48 hours; however, most submissions will be rejected.

Prospective sites are evaluated on the basis of utility alone; neither reciprocal links nor payment is required. Linking to the Value Investing Directory (or any other part of the Gannon On Investing website) will not affect the evaluation process.

If you would like to propose a new category, request a change to your site’s listing, or request the removal of any site, please send an email to [email protected]. All reasonable requests will be considered; however, I reserve the right to list and describe sites in whatever manner I deem to be most useful to my site’s visitors, provided my actions are consistent with the fair use doctrine.

New Additions

Personal Favorites: The Enterprising Investor, Groovy Stocks, Lloyd’s Investment Blog

All new additions by category:

Blogs > Investing Blogs > Lloyd’s Investment Blog

Blogs > Investing Blogs > Value Investing Blogs > Cheap Stocks

Blogs > Investing Blogs > Value Investing Blogs > Deep Wealth

Blogs > Investing Blogs > Value Investing Blogs > Groovy Stocks

Blogs > Investing Blogs > Value Investing Blogs > Mister Market

Blogs > Investing Blogs > Value Investing Blogs > The Enterprising Investor

Blogs > Accounting Blogs > 10Q Detective

Blogs > Accounting Blogs > Found in the Footnotes

Blogs > Accounting Blogs > The AAO Weblog

Online Resources > Investing Communities > The Motley Fool

Online Resources > Investing Communities > The New Wall Street Message Boards

Online Resources > Stock Research > Hoovers

Online Resources > Warren Buffett / Berkshire Hathaway > Sandman’s Place

Online Resources > Warren Buffett / Berkshire Hathaway > Berkshire Hathaway

Online Resources > Value Investing Sites > Focus Investor

Online Resources > Value Investing Sites > Permanent Value

Online Resources > Value Investing Sites > Whitney Tilson’s Value Investing Website

Visit the Value Investing Directory…

Geoff Gannon February 24, 2006

On a Few Quick News Items

Energizer Holdings (ENR) reported earnings yesterday. The stock was up about 10%. I mentioned Energizer Holdings (among many other stocks) in three posts:

On Friday’s Price Drop

On the Rationale for the Overstock Post

On Thirty Interesting Stocks

Disney (DIS) is reported to be about to make an offer to buy Pixar (PIXR). According to some reports, the offer will be made today. Disney is also expected to accept an offer for its ABC radio assets sometime within the next two weeks.

Is Pixar worth $7 billion (or whatever the offer ends up being)? That’s a complicated question. First of all, you have to ask if $7 billion of Disney’s stock at today’s market price is actually worth more or less than $7 billion. What’s the chance that Disney’s stock is currently undervalued and Pixar’s is currently overvalued? It’s a real possibility.

On the plus side, this could mean Disney CEO Robert Iger wants to take Disney in a different direction from what we’ve seen lately. I’ve always thought the real value at Disney would come from providing content not distributing it. If the company really wants to be some sort of “diversified entertainment company” wouldn’t a company built around kids make more sense?

A company focused on animation, theme parks, the Disney Channel, etc. would make more sense to me. In fact, a few years ago, I would have been very happy if Disney announced an acquisition of a toy maker, video game publisher, or licensing company that had something to do with entertaining kids. Today, a lot of Disney’s business isn’t in places where Disney’s powerful kid – oriented properties can be leveraged.

Pixar fits into the kind of company I’d like to see Disney become, but that doesn’t necessarily mean acquiring Pixar is a good move for Disney. After all, Fox Family fits into the kind of company I’d like to see Disney become, but when Eisner decided to buy Fox Family and rebrand it as ABC Family, I though it made no sense (especially at the price he paid). We’ll have to wait for details on the acquisition, but it’s hard to believe Disney is getting much of a bargain here. Still, it’s a step in the right direction.

Over at Value Discipline, a new post just went up entitled “Valuation, Technical Analysis, and Expertise”. The expertise part is especially worth reading.

Happy Hunting…

Geoff Gannon February 23, 2006

News Item: Sherwin-Williams

Sherwin-Williams (SHW) fell 17.82% today on very high volume. Today’s trading was largely the result of a Rhode Island trial jury verdict against Sherwin-Williams and two other former makers of lead paint. A fourth defendant was found not liable. DuPont had also been named in the suit; however, last year, Rhode Island agreed to drop DuPont from the lawsuit when the company agreed to make several million dollars in payments to various government programs and non-profit organizations.

Sherwin-Williams has consistently earned high returns on equity while employing relatively little debt. Investors looking for a bargain may want to research the company and follow the lawsuit. If Sherwin-Williams’ stock price suffers a substantial decline in the weeks or months ahead, expect a blog post from me discussing the company in greater detail.…

Geoff Gannon February 22, 2006

Contest: Coke Defeats SpaceDev

Voting for these two picks ended several days ago, but I didn’t have time to post the results until today.

No surprise here. Coca – Cola (KO) crushed SpaceDev (SPDV.OB) in the most recent round of widest moat contest voting. The final tally: 100% of the vote went to Coke. SpaceDev failed to garner a single vote.

Coke will advance to the final round where it will face Microsoft (MSFT) and a third wide moat company that has yet to be determined. There were some very good email votes this time around. Remember, the person who picks the company that ends up winning the wide moat contest isn’t the only one who will win a copy of Benjamin Graham’s Security Analysis. The author of the best email vote will also receive a free copy of Ben Graham’s magnum opus.

The final pair of entries will be unveiled during the next podcast.

Thank you to everyone who voted.…

Geoff Gannon February 21, 2006

StockBlogs.com

Gannon On Investing has been added to the StockBlogs directory. The directory is the best place to go to find stock market blogs. You’ll notice that several of the blogs in Gannon On Investing’s Value Investing Directory have already been included in the StockBlogs directory. There are also a few worthwhile blogs in the StockBlogs Directory that have yet to be included in GOI’s Value Investing Directory. I hope to correct that error in the weeks ahead.

Visit StockBlogs.com…

Geoff Gannon February 20, 2006

The New Wall Street Message Boards

This is just a quick note to let everyone know The New Wall Street has added message boards. I encourage you all to go over there and get some intelligent discussion going. This is your chance to create an investing community free of the sort of flippant, unthinking posts that mar so many of the major stock specific message boards. I know I’ll be over there a lot. I hope you’ll join me.

Go to The New Wall Street Message Boards…

Suggested Link: Fat Pitch News