Posts In: Gannon on Investing

Andrew Kuhn September 26, 2019

Calculating Free Cash Flow: 5 Illustrated Examples From Actual 10-Ks

Some readers have emailed me with questions about exactly how to calculate free cash flow, including: Do you include changes in working capital? Do you really have to use SEC reports instead of finance websites?

Yes. You really do have to use EDGAR. Finance sites can’t parse a free cash flow statement the way a trained human like you can. As you know, I’m not a big believer in abstract theories. I think you learn by doing. By working on problems. By looking at examples.

Here are 5 examples of real cash flow statements taken from EDGAR.

We start with Carnival (NYSE:CCL).

Notice the simplicity of this cash flow statement. It starts with “net income” (top of page) and then adjusts that number to get to the “net cash provided by operating activities” (yellow). To calculate free cash flow in this case you just take “net cash provided by operating activities” (yellow) and subtract “additions to property and equipment” (green). The result is free cash flow.

As you can see, Carnival produces very little free cash flow. Free cash flow is always lower than net income. That’s because cruise lines are asset heavy businesses like railroads. They have to spend a lot of cash to grow. Carnival’s reported earnings tend to overstate the amount of cash owners could actually withdraw from the business in any one year.

Carnival is our example of a “typical” cash flow statement. There’s really no such thing. But this one is simple in the sense that you only have to subtract one line “additions to property and equipment” from “net cash provided by operating activities” to get Carnival’s free cash flow.

Next up is Birner Dental Management Services (OTC:BDMS).

Notice how Birner separates capital spending into two lines called “capital expenditures” and “development of new dental centers”. This is unusual. And it is not required under GAAP (Generally Accepted Accounting Principles). However, it’s very helpful in figuring out maintenance capital spending. If you believe the existing dentist offices will maintain or grow revenues over the years, you only need to subtract the “capital expenditures” line from “net cash provided by operating activities.” But remember, any cash Birner uses to develop new dental centers is cash they can’t use to pay dividends and buy back stock.

Now for two cash flow statements from the same industry. Here’s McGraw-Hill (MHP) and Scholastic (NASDAQ:SCHL).

These are both publishers. And like most publishers they include a line called “prepublication and production expenditures” or “investment in prepublication cost”. Despite the fact that these expenses aren’t called “capital expenditures”, you absolutely must deduct them from operating cash flow to get your free cash flow number. In fact, these are really cash operating expenses.

For investors, this kind of spending isn’t discretionary at all. It’s part of the day-to-day business of publishing. I reduce operating cash flow by the amounts shown here. At the very least, …

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Andrew Kuhn September 6, 2019

EBITDA and Gross Profits: Learn to Move Up the Income Statement

“In lieu of (earnings per share), Malone emphasized cash flow…and in the process, invented a new vocabulary…EBITDA in particular was a radically new concept, going further up the income statement than anyone had gone before to arrive at a pure definition of the cash generating ability of a business…”

  • William Thorndike, “The Outsiders”


“I think that, every time you (see) the word EBITDA you should substitute the word bullshit earnings.”

  • Charlie Munger


The acronym “EBITDA” stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.

A company’s EPS (which is just net income divided by shares outstanding) is often referred to as its “bottom line”. Technically, EPS is not the bottom line. Comprehensive income is the bottom line. This may sound like a quibble on my part. But, let’s stop and think about it a second.

If EBITDA is “bullshit earnings” because it is earnings before:

  • Interest
  • Taxes
  • Depreciation and
  • Amortization

Then shouldn’t we call EPS “bullshit earnings”, because it is earnings before:

  • unrealized gains and losses on available for sale securities
  • unrealized currency gains and losses
  • and changes in the pension plan?

I think we should. I think both EBITDA and EPS are “bullshit earnings” when they are the only numbers reported to shareholders.

Of course, EPS and EBITDA are literally never the only numbers reported to shareholders. There is an entire income statement full of figures shown to investors each year.

Profit figures further down the income statement are always more complete – and therefore less “bullshit” – than profit figures further up the income statement.


  • EBITDA is always less bullshit than gross profit.
  • EBIT is always less bullshit than EBITDA.
  • EPS is always less bullshit than EBIT.
  • And comprehensive income is always less bullshit than EPS.

Maybe this is why Warren Buffett uses Berkshire’s change in per share book value (which is basically comprehensive income per share) in place of Berkshire’s EPS (which is basically net income per share). Buffett wants to report the least bullshit – most complete – profit figure possible.

So, if profit figures further down the income statement are always more complete figures, why would an investor ever focus on a profit figure higher up the income statement (like EBITDA) instead of a profit figure further down the income statement (like net income)?


Senseless “Scatter”

At most companies, items further up the income statement are more stable than items further down the income statement.

I’ll use the results at Grainger (GWW) from 1991 through 2014 to illustrate this point. The measure of stability I am going to use is the “coefficient of variation” which is sometimes also called the “relative standard deviation” of each series. It’s just a measure of how scattered a group of points are around the central tendency of that group. Imagine one of those human shaped targets at a police precinct shooting range. A bullet hole that’s dead center in the chest would rate a 0.01. A bullet hole that …

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Andrew Kuhn September 5, 2019

Why Are U.S. Banks More Profitable Than Banks in Other Countries?


A Focused Compounding member asked me this question:

“Have you any thoughts on why U.S. banks are so profitable (the better ones at least)? I’ve looked at banks in other countries (the U.K. and some of continental Europe) and banks there really struggle to earn the spreads and returns on equity of high quality U.S. banks. This is particularly strange as the U.S. banking market is actually pretty fragmented, certainly more so than the U.K. which is dominated by a few giant banks and has a pretty non competitive deposit market. But U.S. banks seem to earn far better returns.

I was discussing this recently with someone who is a consultant to banks advising them in regulatory capital (among other things) and he said that it was down to the regulatory capital requirements being looser in the U.S. I’m really not convinced by that explanation though.
Is this something you’ve thought about at all?”

I don’t know if the regulatory requirements are looser really. There’s one aspect of regulation nothing about outside the U.S.: fees. It may be that U.S. banks are better able to earn non-interest income on fees (not sufficient funds fees, charging monthly fees for accounts below a certain minimum, etc.) then banks in some countries, because there might be tougher consumer protection rules in some other countries. However, from what I know of U.S. regulatory rules as far as capital requirements versus banks in other countries – I don’t really agree. It’s not that common for me to feel a bank in another country is a lot safer than large U.S. banks. So, if it’s a regulation advantage. It doesn’t seem to be an advantage due to forcing banks in other countries to be too safe.

The U.S. has FDIC. I don’t know what programs in other countries are like. Obviously, the FDIC program in the U.S. – combined with some other rules – helps minimize rivalry for deposits. An unsafe bank shouldn’t be able to draw deposits away from a safe bank just by offering high interest rates on deposits. And depositors shouldn’t abandon a bank they like just because they learn it may be about to fail. Obviously, before the FDIC and other rules – those were concerns which could mean the weakest operators in the industry would lower profitability for the strongest operators through irrationally intense rivalry for deposits.

Negative rates are bad for banks. There could be cyclical reasons for why you are seeing poor results in parts of Europe, because of that.

However, I need to warn you that it’s NOT true that small U.S. banks are more profitable than banks in other countries. They aren’t. It’s ONLY banks with good economies of scale in the U.S. that even earn their cost of capital. My estimate when I looked at U.S. banks as a group is that since about World War Two, they haven’t earned their cost of capital and they have earned returns below the S&P …

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Andrew Kuhn September 4, 2019

How I Analyze Bank Stocks





We did a Focused Compounding Podcast episode that was 100% dedicated to bank investing:


In that podcast notice that I analyze banks completely differently than most value investors. I don’t believe price-to-book is an especially important metric. I value banks based on the amount of their share price, their deposits per share (so P/Deposits so to speak), their growth in deposits, and finally the profitability of those deposits (how low cost are they, how “sticky” are they).


I spend very little time on the asset side of the bank except to see if I think it is safe enough for me. I just assume – and this assumption isn’t 100% correct or anything – that money is a commodity, so banks will make roughly similar amounts over time on whatever they lend out, buy bonds with, etc.


However – at least among U.S. banks – you have banks that pay very different amounts on their deposits (in interest), and even MORE important very, VERY different amounts in terms of non-interest expenses per dollar of deposits. There are banks in the U.S. that have $50 million per branch and pay HIGHER interest on most deposits compared to banks that have $200 million per branch. The bank with 4 times the deposits per branch brought in with MORE non-interest bearing accounts is going to have such a “all-in” cost advantage over the other bank that it can make fewer loans and buy more bonds, it can make safer loans that yield less, it can buy shorter-term bonds that yield less, etc. and it’ll still make more money than the bank that has to hustle to make the highest yielding loans, buy the highest yielding bonds, etc.


My belief is that a strong, durable advantage on the deposits side in terms of economies of scale at the customer level and the branch level especially is what creates value in banking.


It’s not impossible to create value in other ways. Prosperity Bank has done this. But, taking in a lot of small deposits from a lot of less wealthy people at a lot of different branches means the only way you can succeed would be extreme penny pinching on the deposit side and then really good lending on the asset side. You’d have to be cheaper than the other guys when it comes to running a customer oriented business and/or you’d have to be smarter, more driven, etc. lenders. I think that’s tough.


Recently, I also wrote-up Truxton (TRUX). You can see the same focus on economies of scale here, because:


1) Truxton operates BOTH a wealth management business and a private bank out of the location that is ALSO ITS HEADQUARTERS

2) Truxton has about 8x more deposits per branch (it only has one branch) than U.S. banks generally

3) Truxton focuses on RICH clients (this means Truxton might get 10x the dollar amount of deposits from each depositor …

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Andrew Kuhn September 3, 2019

Why You Might Want to Stop Measuring Your Portfolio’s Performance Against the S&P; 500

By Geoff Gannon

December 8, 2017



Someone emailed me this question about tracking portfolio performance:

“All investors are comparing their portfolio performance with the S&P 500 or DAX (depends were they live). I have asked a value investor why he compared the S&P 500 performance with his portfolio performance…for me as a value investor it makes no sense. A value investor holds individual assets with each of them having a different risk…it’s like comparing apples and oranges.

The value investor told me that…Warren Buffett compares his performance with the S&P 500. But I believe he did it, because other investors…expect it or ask for such a comparison.

How do you measure your portfolio success? Do you calculate your average entry P/E and compare it with S&P500 or Dow P/E to show how much you (over)paid for your assets? Or do you avoid such a comparison and calculate only the NAV of your portfolio?”

I don’t discuss my portfolio performance on this blog.

And I think it’s generally a good idea not to track your portfolio performance versus a benchmark.

It’s certainly a bad idea to monitor your performance versus the S&P 500 on something as short as a year-by-year basis.


Well, simply monitoring something affects behavior. So, while you might think “what’s the harm in weighing myself twice a day – that’s not the same thing as going on a diet” – in reality, weighing yourself twice a day is a lot like going on a diet. If you really wanted to make decisions about how much to eat, how much to exercise, etc. completely independent of your weight – there’s only one way to do that: never weigh yourself. Once you weigh yourself, your decisions about eating and exercising and such will no longer be independent of your weight.

Knowing how much the S&P 500 has returned this quarter, this year, this decade, etc. is a curse. You aren’t investing in the S&P 500. So, tethering your expectations to the S&P 500 – both on the upside and on the downside – isn’t helpful. The incorrect assumption here is that the S&P 500 is a useful gauge of opportunity cost. It’s not.

Let me give you an example using my own performance. Because of when the 2008 financial crisis hit, we can conveniently break my investing career into two parts: 1999-2007 and 2009-2017.

Does knowing what the S&P 500 did from 1999-2007 and 2009-2017 help me or hurt me?

It hurts me. A lot.

Because – as a value investor – the opportunities for me to make money were actually very similar in 1999-2007 and 2009-2017. In both periods, I outperformed the S&P. However, my outperformance in 2009-2017 was small while my outperformance in 1999-2007 was big. In absolute terms, my annual returns were fairly similar for the period from 1999-2007 and 2009-2017. It is the performance of the S&P 500 that changed.

Many value investors have a goal to outperform the S&P 500. But, is …

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Geoff Gannon August 24, 2019

Monarch Cement (MCEM): A Cement Company With 97 Straight Years of Dividends Trading at 1.2 Times Book Value


This is my initial interest post for Monarch Cement (MCEM). I’m going to do things a little differently this time. My former Singular Diligence co-writer, Quan, emailed me asking my thoughts on Monarch as a stock for his personal portfolio. I emailed him an answer back. I think that answer will probably help you decide whether you’d want to buy this stock for your own portfolio better than a more formal write-up. So, I’ll start by just giving you the email I sent Quan on Monarch Cement and then I’ll transition into a more typical initial interest post.



I think Monarch is a very, very, VERY safe company. Maybe one of the safest I’ve ever seen. If you’re just looking for better than bond type REAL returns (cement prices inflate long-term as well as anything), I think Monarch offers one of the surest like 30-year returns in a U.S. asset in real dollars.


Having said that, I don’t think it’s as cheap or as high return as you or I like as long as the CEO doesn’t sell it. And the CEO very clearly said: “Monarch is not for sale”. 


I’m basing a lot of my comments in this email on historical financial data (provided by Monarch’s management) for all years from 1970-2018.


In a couple senses: the stock is cheap. It would cost more than Monarch’s enterprise value to build a replacement plant equal to the one in Humboldt, Kansas. And no one in the U.S. is building cement plants when they could buy cement plants instead. The private owner value in cement plants is even higher than the replacement value. An acquirer would pay more to buy an existing plant than he would to build a new plant with equal capacity. The most logical reason for why this is would be that an acquirer is an existing cement producer who wants to keep regional, national, global, etc. supply in cement low because his long-term returns depend on limiting long-term supply growth in the industry he is tied to – and, more importantly, anyone seeking to enter a LOCAL cement market needs to keep supply down because taking Monarch’s current sales level and cutting it into two (by building a new plant near Monarch’s plant) would leave both plants in bad shape (too much local supply for the exact same level of local demand). Fixed costs at a cement plant are too high to enter a local market like the ones Monarch serves by building a new plant. You’d only get an adequate return on equity if you bought an existing plant. Therefore, I believe that it’s usually the case that the price an acquirer would pay for a cement plant – and certainly Monarch’s plant given its location far inland in the U.S. – is greater than what it would cost to replace the existing plant. So: Acquisition Offer > Replacement Cost. And, in this case, Replacement Cost …

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Andrew Kuhn August 20, 2019

The Moat Around Every Ad Agency is Client Retention

April 24, 2016

By Geoff Gannon

Moat is sometimes considered synonymous with “barrier to entry”. Economists like to talk about barriers to entry. Warren Buffett likes to talk about moat. When it comes to investing, “moat” is what matters. Barriers to entry may not matter. Thinking in terms of barriers to entry can frame the question the wrong way.

If you’re thinking about buying shares of Omnicom and holding those shares of stock forever – what matters? Do barriers to entry matter? Does it matter if it’s easy to create one new ad agency or a hundred new ad agencies? No. What matters is the damage any advertising company – whether it’s WPP, Publicis, or a firm that hasn’t been founded yet – can do to Omnicom’s business. How much damage can a new entrant do to Omnicom’s intrinsic value? How much damage can Publicis or WPP do to Omnicom? The answer is almost none. In that sense, the barriers to entry in the advertising industry are low but the moat around each agency is wide. How can that be?

First of all, the historical record is clear that among the global advertising giants we are talking about a stable oligopoly. The best measure of competitive position in the industry is to use relative market share. We simply take media billings – this is not the same as reported revenue – from each of the biggest ad companies and compare them to each other. If one company grows billings faster or slower than the other two – its competitive position has changed in relative terms. Between 2004 and 2014, Omnicom’s position relative to WPP and Publicis didn’t change. Nor did WPP’s relative to Publicis and Omnicom. Nor did Publicis’s position relative to WPP and Omnicom. Not only did they keep the same market share order 1) WPP, 2) Publicis, 3) Omnicom – which is rarer than you’d think over a 10-year span in many industries – they also had remarkably stable size relationships. In 2005, WPP had 45% of the trio’s total billings. In 2010, WPP had 45% of the trio’s combined billings. And in 2014, WPP had 44% of the trio’s combined billings. Likewise, Omnicom had 23% of the trio’s billings in 2005, 22% in 2010, and 23% in 2014. No other industries show as stable relative market shares among the 3 industry leaders as does advertising. Why is this?

Clients almost never leave their ad agency. Customer retention is remarkably close to 100%. New business wins are unimportant to success in any one year at a giant advertising company. The primary relationship for an advertising company is the relationship between a client and its creative agency. The world’s largest advertisers stay with the same advertising holding companies for decades. As part of our research into Omnicom, Quan looked at 97 relationships between marketers and their creative agencies.

I promise you the length of time each marketer has stayed with the same creative agency will surprise you. Let’s look …

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Andrew Kuhn August 17, 2019

Insider Buying vs. Insider Incentives

December 17, 2017

by Geoff Gannon

A blog reader sent me this email:

Do you ever pay attention to insider transactions when analyzing a company?”

I do read through lists of insider buys from time-to-time. I follow a blog that covers these kind of transactions. But, I can’t think of any situation where I incorporated insider buying or selling into my analysis.



Learn How Executives are Compensated

I can, however, think of situations where a change in how insiders were compensated was included in my analysis. For example, years ago, I was looking at a stock called Copart (CPRT). It had a high enough return on capital and generated good enough cash flow that it was going to have more cash on hand than it could re-invest in the business pretty soon. Up to that point, it had been able to plow a lot of the operating cash flow back into expanding the business. However, it seemed like they had gotten too big to keep that up. So, they were going to have to buy back stock, pay a dividend, do an acquisition, or let cash pile up on the balance sheet.

I saw that the Chairman and the CEO (two different people, the CEO is the Chairman’s son-in-law) were now going to be compensated in a form that meant the share price a few years down the road is what mattered (if I remember right: compensation would now be a big block of five-year stock options combined with an elimination of essentially all other forms of compensation for those next 5 years). I had also read an interview with the Chairman (it was an old interview I think) where he didn’t strike me as the kind of person who was going to venture out beyond his circle of competence if and when he had too much cash.

So, I felt the likelihood of big stock buybacks happening soon was high.

To answer your question: no, I don’t really pay attention to insider buying and selling. But, yes, I do pay attention to whether insiders own a lot of stock, how they are compensated (what targets the company has for calculating bonuses), etc.

I can think of one situation where both the company and the CEO were buying a lot of stock at the same time. And, I should have bought that stock. If I had, I would’ve made a ton of money. However, to be honest, even if the CEO wasn’t buying shares and the company wasn’t buying back stock I should’ve seen this was a stock to bet big on.

It was trading for less than the parts would’ve fetched in sales to private owners. It was an obvious value investment. And that’s probably why insiders were buying.



Insiders Are Like You – Only Confident

Insiders tend to be value investors in their own companies. So, I think outside investors assume that insiders are acting more on inside information and less on

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Andrew Kuhn August 15, 2019

How to Quantify Quality

By Geoff Gannon on November 2, 2013


Someone who reads the blog sent me this email:

I kind of understand the quantitative part of stock analysis (such as number crunching, valuation) but really struggle to understand the qualitative aspects which determine quality. What kinds of questions to ask yourself in order to gain more insights into the qualitative?

A qualitative analysis does not have to be any less evidence based than a quantitative analysis. However, you do have to gather the evidence yourself.

What counts as evidence? How can we separate our own biases, speculation about the future, etc. from actual observations of quality? Evidence is fact based. Facts come in several flavors.


Example: Tiffany’s New York Flagship Store had $305.54 million in sales in 2012. That is $6,671 per square foot. Based on calculation made from data given in Tiffany’s 10-K on percentage of sales at flagship, worldwide net sales, and gross retail square footage of flagship.


Example: John Wiley, Reed Elsevier, Springer, etc. have bargaining power with their customers.

The largest (academic journal) publishers wield the power…as a former colleague of mine once said, ‘the more journals you have, the higher your usage stats are and the more money you can charge.”

Based on discussion with a university press editor.


Example: Over the last 10 years, I have placed an average of one order every 4 to 10 days with Amazon. At no point in the last 10 years, have I ever made less than one order every 10 days. I have been a member of Amazon Prime since 2006. The number of orders made each year has roughly tripled from 2003 to 2013. It doubled after I became a Prime member.

Based on information found in my own order history for 2003 to 2013 at Amazon.


Example: The 4 most successful periods in animation were at 3 companies: Disney (twice), Pixar, and DreamWorks. At the time of their success, these companies were run by Walt Disney, Jeffrey Katzenberg, John Lasseter, and Jeffrey Katzenberg (again). All worked at Disney at some point in their career.

Based on more than half a dozen books on Disney, Pixar, and DreamWorks.



377 participants were assigned to (Weight Watchers), of whom 230 (61%) completed the 12-month assessment; and 395 were assigned to standard care, of whom 214 (54%) completed the 12-month assessment. In all analyses, participants in the commercial programme group lost twice as much weight as did those in the standard care group.

Based on a journal article appearing in The Lancet.

As you can see, there is no need to be less evidence based when analyzing a business’s quality than you are when analyzing its price. However, you have to impose an evidence based discipline on yourself. You have to go through the primary sources and extract the relevant facts on your own. They will not be presented in as easily digestible form like an EV/EBITDA ratio on Yahoo Finance. When …

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Andrew Kuhn August 13, 2019

Why I Don’t Use WACC

December 14, 2017

by Geoff Gannon

A blog reader emailed me this question about why I appraise stocks using a pure enterprise value approach – as if debt and equity had the same “cost of capital” – instead of using a Weighted Average Cost of Capital (WACC) approach:


“…debt and equity have different costs. In businesses with a (large) amount of the capital provided by debt at low rates, this would distort the business value. In essence I am asking why do you not determine the value of the business using a WACC, similar to how Professor Greenwald proposes in Value Investing: From Graham to Buffett and Beyond. The Earnings Power Value model seems theoretically correct, but of course determining WACC is complicated and subject to changes in the future. Nevertheless, your approach of capitalizing MSC at 5% is basically capitalizing the entire business value, including the amount financed by debt, at what is presumably your cost of equity for a business with MSC’s ROIC and growth characteristics. Perhaps I am coming at this from a different angle than you, but it seems a little inconsistent from the way I am thinking about it, and for businesses with more debt this would lead to bigger distortions. AutoNation would be a good example of a business with meaningful…debt that this approach would distort the valuation on.”


When I’m doing my appraisal of the stock – this is my judgment on what the stock is worth not whether or not I’d buy the stock knowing it’s worth this amount – I’m judging the business as a business rather than the business as a corporation with a certain capital allocator at the helm. Capital allocation makes a huge difference in the long-term returns of stocks. You can find proof of that by reading “The Outsiders”. Financial engineering makes a difference in the long-term returns of a stock. You can read any book about John Malone or Warren Buffett to see that point illustrated.


But, for me…


My appraisal of Berkshire Hathaway is my appraisal of the business independent of Warren Buffett. Now, knowing Warren Buffett controls Berkshire Hathaway would make me more likely to buy the stock and to hold the stock. So, it’s an investment consideration. But, it’s not an appraisal consideration for me. When I appraise Berkshire Hathaway, I appraise the businesses without considering who is allocating capital. Otherwise, I’d value Berkshire at one price today and a different price if Warren died tomorrow. I don’t think that’s a logical way to appraise an asset. Although I do think that buying an asset that’s managed by the right person is a good way to invest.


A good example of this is DreamWorks Animation (now part of Comcast). Quan and I valued DreamWorks Animation at a level that was sometimes more than double the stock’s price.


There was a point where we could have bought the stock at probably 45% of what we thought the business was

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