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 know both how good a business is and how cheap it is, before you buy.
I think return on equity, return on capital, return on retained earnings, the gross margin, the profit margin, and the FCF margin are all useful measures of profitability.
I understand why you might want to use enterprise value-to-EBITDA ratio, especially because it is a widely available metric. Personally, I use normalized pre-tax owner’s earnings for valuing a predictable, slow-growing business that is not a consumer monopoly. In some cases, an appropriate EV/Sales ratio based on a normalized FCF margin might work even better.
I mentioned VLGEA before. That’s an example of a company I would value on the basis of normalized pre-tax owner’s earnings. Energizer Holdings (ENR) is the kind of company I would value on the basis of a normalized free cash flow margin and the current level of sales (adjusted for a conservative annual revenue growth rate). So, for Energizer, EV/Revenue is more appropriate than it would be for Village.