Journeys of a Bumbling Investor

On why ROIC instead of ROE/ROA:

ROE and ROA are distorted due to differing debt levels and tax rates. It does not allow you to measure the true underlying “returns generating capability” of the company.

Quoting an example from Greenblatt’s book, you can imagine that you can have Company A that has no debt, and Company B that has $50 in debt. The price of Company A is $60. The price of Company B is $10 per share. These two companies can have the same sales, operating earnings, enterprise value, etc. That is, it costs the same to purchase each company, and you get the same operating earnings, However, Company B will have a higher ROE than Company A because it took on more leverage. Hence even though both companies are “as capable” in generating returns, using ROE distorts the measurement due to leverage. To find good companies, we should target those with good ROIC/ROC instead.

On Not subtracting “excess cash” when calculating Invested Capital:

I guess excess “cash” do not literally mean cash cash. For example in the case of Microsoft, Berkshire Hathaway, or companies that have built up a “cash” hoard, most of those cash are in some short-term investments.

In those cases, the cash-equivalents might be earning a rate of return greater than what general shareholders could’ve earned, and those returns are not earned from the main operations of the company.

As such, I think those excess cash should still be subtracted, so that we can measurely accurate the “returns generating capability” of a company from its normal main operations.

On Moving across Capital Structures:

Those two companies are indeed equivalent. For example, you can buy Company A at $60, and then borrow $50. What you end up with is Company B. Similarly, you can buy Company B for $10, pay down the $50 debt, and end up with Company A. In a simplistic sense, a company can ‘move around’ capital structures. The thing that allows you to see that the two companies are “essentially equivalent” in terms of returns generating capability, is that the enterprise value for both are the same, and the EBIT for both are the same.

I agree that taking on leverage will have a tax benefit, and can improve your results in good times, and worsen your results in bad times. However, when we want to determine the true “returns generating capability” of a company (i.e. what is the returns that the company can generate using its assets (don’t confuse this with equity)), then we need to take leverage out of the equation to prevent distortion as previously explained.

You can think of it as a 2-step process:

1. First, is to determine the fundamental returns-generating capability of companies. That will result in a tie between Company A and Company B (i.e. same gross profit using the same amount of assets).
2. Next, you can look at the amount of leverage the 2 companies are taking on. Whether the company is consistently making more than its cost of capital, if so, then the company might be a better buy. Or whether the company is making less than its cost of capital, then even though the P/E is low due to the leverage, it may not be a good buy, etc.

As a final note, it is good to emphasize that the yardstick to use, to compare against a company’s Cost of Capital, is the ROIC. If ROIC > Cost of Capital, then growth is constructive/additive. If ROIC < Cost of Capital, then growth is destructive.

Quotes from Warren Buffett's speech at the University of Florida School of Business on October 15, 1998: 

"… if you $100 million at the beginning of the year, and you will make 10% if you are unleveraged, and 20% if you are leveraged…. what difference if at the end of the year, you have $110 million or $120 million? It makes no difference!… The downside, especially if you are managing other people's money, is not only losing all your money, but it is the disgrace, humiliation and facing friends whose money you have lost…."

On LTCM: "… to make money that they didn't have and didn't need, they risked what they did have and what they did need. That is just plain foolish…. If you risk something that is important to you for something that is unimportant to you, it just doesn't make sense."

Quote from Dr A. Gary Shilling:

"Markets can remain illogical longer than you or I can remain solvent". 

I think Warren Buffett once said this of Investing:

Rule No.1: Never lose money.
Rule No.2: Never forget Rule No.1

I had thought that I fully understood the rules, but apprantly not well enough to practice it =)

A more pertinent rule to hammer in would be “Margin of Safety“. Though its a means to the end, the clarity and size of this “gate” should be sufficient.

So, one of the companies I'm in is not going to file its 10-K on time, and is potentially going to get delisted. Hence my "sudden" interest in this topic =)

To summarize, for the NYSE, a company gets a grace period of 9 months from the deadline, after which NYSE will determine whether or not to let the ticker to continue to trade (up to a period of 3 months more). For the NASDAQ, there is no such grace period.

See http://www.thecorporatecounsel.net/blog/archive/000621.html and http://www.sec.gov/rules/sro/nyse/34-51777.pdf for more information on the NYSE and NASDAQ stance on delisting for late filing of 10-Ks.

See http://www.secfile.net/SEC_calendar.htm for filing deadlines. Definitions of "accelerated filer, etc." can be found here http://www.law.uc.edu/CCL/34ActRls/rule12b-2.html.

From my readings, my impression is that a company is able to officially request for an extension to the filing deadline, for both NYSE and NASDAQ, despite the fact for example that NASDAQ does not have a grace period.

The process/formula to obtain the Instrinsic Value (IV) of a firm using Discounted Cash Flow (DCF) is very similar to the process for calculating a firm's Enterprise Value (EV). I had wanted to see the logical link between these two values.

To summarize and simplify, let FV = value of the firm due to the discounted future free cash flows. Then we have IV = FV + Cash – Debt. By definition from the formula, IV = money you get from liquidating the company.

In the case of calculating EV, we have EV = Market Value (MV) – Cash + Debt. By definition again, EV = money you need to use to buy the company and clear all debts.

Re-arranging the IV formula, we have FV = IV – Cash + Debt. At this point, the equation of FV and EV looks very similar.

Now, note that if say MV < IV, then theoretically we can buy the company (keeping the debt) using MV, and liquidate the company to receive IV, and make the spread. Hence it is clear that MV should be compared with IV.

On the other hand, EV should be compared with FV, and not IV. Note that when MV = IV, then EV = FV. Why should the Enterprise Value be equal to the discounted future free cash flow value? Because, if you were to move in and buy a company using EV, this will settle the debt and the cash, i.e the "current capital structure and excess cash part" is settled, so what you have effectively paid for (i.e. what is left behind), is purely the future cash flows of the business (unleveraged), i.e. FV.