Growth in profits have LITTLE role in determining intrinsic value.

Growth in profits have LITTLE role in determining intrinsic value.  It is the amount of capital used that will determine value.  The lower the capital used to achieve a certain level of growth, the higher the intrinsic value.


Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor."

If understood in their entirety, the above paragraph will surely make the reader a much better investor.

Growth in profits will have little role in determining value. It is the amount of capital used that will mostly determine value. Lower the capital used to achieve a certain level of growth, higher the intrinsic value.

There have been industries where the growth has been very good but the capital consumed has been so huge, that the net effect on value has been negative. Example - US airlines.

Hence, steer clear of sectors and companies where profits grow at fast clip but the return on capital employed are not enough to even cover the cost of capital.

****Buffett (1992): Do not categorise stocks into growth and value types, the two approaches are joined at the hip

Warren Buffett's 1992 letter to his shareholders touched upon his views on short-term forecasting in equity markets and how it could prove worthless. In the following few paragraphs, let us go further down through the letter and see what other investment wisdom he has on offer.

Most of the financing community puts stock investments into one of the two major categories viz. growth and value. It is of the opinion that while the former category comprises stocks that have potential of growing at above average rates, the latter category stocks are likely to grow at below average rates. However, the master belongs to an altogether different camp and we would like to mention that such a method of classification is clearly not the right way to think about equity investments. Let us see what Buffett has to say on the issue and he has been indeed very generous in trying to put his thoughts down to words.

"But how, you will ask, does one decide what's 'attractive'? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: 'value' and 'growth'. Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

In addition, we think the very term 'value investing' is redundant. What is 'investing' if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).

Whether appropriate or not, the term 'value investing' is widely used. Typically, it connotes the purchase of stocks having attributes such as 

• a low ratio of price to book value, 
• a low price-earnings ratio, or 
• a high dividend yield. 

Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments.

Correspondingly, opposite characteristics - 

• a high ratio of price to book value, 
• a high price-earnings ratio, and 
• a low dividend yield 

- are in no way inconsistent with a 'value' purchase.

Similarly, business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor."

If understood in their entirety, the above paragraphs will surely make the reader a much better investor. We believe the most important takeaways could be as follows:

• Do not categorise stocks into growth and value types. A high P/E or a high price to cash flow stock is not necessarily a growth stock. A low P/E or a low price to cash flow stock is not necessarily a value stock either. 
• Growth in profits will have little role in determining value. It is the amount of capital used that will mostly determine value. Lower the capital used to achieve a certain level of growth, higher the intrinsic value. 
• There have been industries where the growth has been very good but the capital consumed has been so huge, that the net effect on value has been negative. Example - US airlines. 
• Hence, steer clear of sectors and companies where profits grow at fast clip but the return on capital employed are not enough to even cover the cost of capital.
  
  
  
  
  http://www.equitymaster.com/detail.asp?date=12/20/2007&story=2

Quality check to weed out company with an insatiable demand for capital.

Quality check to weed out company with an insatiable demand for capital.

Benjamin Graham and followers placed great emphasis on financial strength, liquidity, debt coverage and so on. It was the tune of the times.

Credit analysis today continue to check all manner of coverage (e.g. interest coverage) and debt ratios, but for most companies reporting a profit, it maybe overkill.

Here are a few checks to provide a margin of safety and a further test of whether the company has an insatiable demand for capital:

1. Are current assets (besides cash) rising faster than the business is growing?

This ties to the asset productivity and turnover measures but it is worth one last check to see whether a company is buying business by extending too much credit.

More receivables result from extending credit.

Losing channel structure and supply chain battles (customers and distributors won't carry inventory; suppliers are making them carry more inventory) result in increased inventories.

In a soft construction environment, distributors and retailers like Home Depot and Lowe's simply aren't taking as much inventory, pushing it back up the supply chain. The main supplier's risk is greater capital requirements and expensive impairments downstream.

2. Is debt growing faster than the business growth?

Over a sustained period, debt rising faster than business growth is a problem.

If the owners won't kick in to grow the business, and if retained earnings aren't sufficient to meet growth, what does that tell you? The business is forced to seek capital.

3. Repeated trips to the financial markets?

If the business continually has to approach the capital markets (other than in startup phases), that again is a sign that internally generated earnings and cash flows are not sufficient.

Once in a while it is okay, but again one is looking to weed out chronic capital consumers.

Two important things in the capital structure of the business

Capital Structure

When looking at capital structure, try to determine two things:

1. Is the business a consumer or producer of capital? Does it constantly require capital infusions to build growth or replace assets? Warren Buffett - and many other value investors - shun businesses that cannot generate sufficient capital on their own. In fact, one of the guiding principles behind Berkshire Hathaway is the generation of excess capital by subsidiary businesses that can be deployed elsewhere.

2. Is the business properly leveraged? Overleveraged businesses are at risk and additionally burden earnings with interest payments. Under-leveraged businesses, while better than overleveraged, may not be maximizing potential returns to shareholders.

Capital-intensive and Capital-hungry companies

CAPITAL SUFFICIENCY

Capital-hungry companies are sometimes hard to detect, but there are a few obvious signs.

Companies in capital-intensive industries, such as manufacturing, transportation, or telecommunications, are likely suspects.

Here are a few indicators.

1. Share buybacks

The number of shares outstanding can be a real simple indicator of a capital hungry company. A company using cash to retire shares - if acting sensibly - is telling you that it generates more capital than it needs. On the other hand, if you look at a company like IBM, ROE has grown substantially, and massive share buybacks are a major reason.

Warning! : When evaluating share buybacks, make sure to look at actual shares outstanding. Relying on company news releases alone can be misleading. Companies also buy back shares to support employee incentive programs or to accumulate shares for an acquisition. Such repurchases may be okay but aren't the kind of repurchases that increase return on equity for remaining owners. (Comment: to take a look at HaiO share buyback.)

2. Cash flow ratio

Is cash flow from operations enough to meet investing requirements (capital assets being the main form of investment) and financing requirements (in this case, the repayment of debt)?

If not, it's back to the capital markets. This figure is pretty elusive unless you have - and study - statements of cash flow.

3. Lengthening asset cycles

If accounts receivable collection periods and inventory holding periods are lengthening (number of days' sales in accounts receivable and inventory), that forewarns the need for more capital.

4. Working capital

A company requiring steady increases in workng capital to support sales requires, naturally, capital. Working capital is capital.