25 November 2002 00:00 [Source: ICB Americas]At a time when balance sheets are under great scrutiny, the choice of what metric should be used in making company valuations has become increasingly significant. Many Wall Street analysts in general and chemical industry analysts in particular are emphasizing cash flow-based analysis to make judgments about company performance.
One important metric is discounted cash flow (DCF). DCF analysis seeks to determine the current value of a company based on its estimated future cash flows. Estimated free cash flows (operating profit + depreciation + amortization of goodwill - capital expenditures - cash taxes + change in working capital) are discounted to a present value using the company's weighted average cost of capital (WACC).
The DCF formula that Bank of America Securities analyst Mark Gulley employs is the classic "dividend discount model," using appropriate growth and discount rates, where "dividend" as a term is synonymous with the free cash flow (FCF) generated by the firm. FCF is defined as net earnings plus depreciation and amortization charges, minus changes in working and maintenance capital. "Convention dictates that we use a 10-year period for our calculation, usually with a 3 percent terminal growth rate attached," he says. "Otherwise you get ridiculous valuations by not assuming that eventually growth rates regress to the mean. DCF doesn't look at historical multiples, or, for that matter, historical relative multiples, or even historical S&P multiples. It looks only at the company going forward."
The Banc of America analyst emphasizes the value of such an approach. "In light of recent events with accounting regarding revenue recognition and capitalized expenses," says Mr. Gulley, "earnings quality is of increasing concern. We think free cash flow is the most transparent metric to gauge company performance. It's hard to fool the cash register."
Banc of America Securities' ranking of specialty chemical companies based on cash flow yield has 3M, Albemarle and Cambrex leading the pack, and the catalyst companies, which are prone to grow the top line at the expense of cash flow, ranking near the bottom. "DCF captures several shareholder value drivers: expected growth in operating earnings, capital efficiency, balance sheet capital structure, cost of equity and debt, expected duration of growth and terminal growth rate," says Mr. Gulley. "The fact the DCF is less likely to be misled by aggressive accounting has to be viewed as an added plus."
However, he notes that a key limitation in doing a forward-looking free cash flow analysis is "the lack of visibility regarding changes in working capital...which, for some companies, can be unpredictable, with positive or negative swings that could have a material effect on FCF assumptions."
Using an analogy borrowed from the world of rental real estate investments, Mr. Gulley remarks: "An apartment's value is measured in terms of projected future rental income, not what the apartment cost, or what neighborhood it's located in." Qualitative factors drive the rental income assumption, of course, but the present value of the future expected stream is the meaningful number derived. In selecting a stock, he looks at all the qualitative factors on a company-by-company basis, but then filters the recommendation through the DCF metric as a reality check, "just to make sure I'm not out of line," says the analyst.
Given the capital-intensive nature of the chemical industry, other analysts point to the value of looking at return on capital. A return-on-capital metric is relevant, says Deutsche Bank Securities analyst David Begleiter, because it captures both the growth element and the capital employed. "Growth is important," he notes, "but only in the context of how much capital is required to generate it."
The debt/equity ratio in the chemical industry is typically 35 percent debt and 65 percent equity, or it may range to a 40/60 ratio. "What's more relevant, to me," he says, "is debt/EBITDA (earnings before interest, taxes, depreciation and amortization), a cash-on-cash comparison, which I prefer. There's a 2:1 to 2.5:1 ratio that's normal for the industry. The traditional debt/equity ratio may not be all that instructive, given the large numbers of write-downs we've had of late," he says.
An operating ratio that Mr. Begleiter is fond of contains NOPAT (net operating profit after taxes) in the numerator, and a denominator that captures every dollar invested in the business. To hold a company's feet to the fire, he adds back the after-tax portion of asset write-offs. "If they spent a billion dollars on a failed ethylene plant, sorry guys." He also adds back to the denominator the amount of goodwill amortization. "If they overpaid for an acquisition, again, sorry guys." In times of debt stress and accounting gimmicks that often inflate reported results, the reliance on cash measures become paramount. "How much cash have you invested in the business?" he asks. "And what's the return on that cash employed?"
Lehman Brothers analyst Sergey Vasnetsov, favors a ratio of total enterprise value (TEV) to EBITDA, or debt plus equity to cash flow earnings. Other ratios that he finds useful include price to cash flow (stock price to cash flow per share), and also the traditional price/earnings (P/E) ratio. "These days-the past year-and-a-half-we're looking more at debt ratings, interest coverage and pre-cash flow generation," he says. "Some of the smaller commodity companies, Lyondell, Millennium and Georgia Gulf, for instance, turned out to be highly levered. When the good times return, these factors, certainly important at the bottom of the cycle, won't be discarded, but they tend to be de-emphasized."
Drilling down to the company or stock selection level, qualitative measures come to the fore, says Mr. Vasnetsov. Key questions that the analyst addresses include: How strong is the management? How clean is the company's reporting system? Are there any potential noteworthy environmental, pension or other legal liabilities that could impact future cash flow needs? Mr. Vasnetsov cites the bankrupt W.R. Grace as an example of an operating company with good product lines that was taken down because of an insurmountable environmental factor, namely asbestos. The rampant abuses of pro forma accounting, he notes, were more prevalent in the high-tech areas of investing, where, in some cases, they were so significant as to completely overshadow or camouflage the operating earnings picture of those firms. Those particular excesses were not conspicuously present in chemicals.
One fallout from the new FD (Fair Disclosure) regulation is that companies have pretty much buttoned-up on the subject of forward-looking statements, says Mr. Vasnetsov. The US Securities and Exchange Commission's Regulation FD is an issuer disclosure rule that addresses selective disclosure. The regulation provides that when an issuer, or person acting on its behalf, discloses material nonpublic information to certain enumerated persons (in general, securities market professionals and holders of the issuer's securities who may well trade on the basis of the information), it must make public disclosure of that information.
Analysts have to go over the official documents, the 10-K and the Annual Report with an even finer toothcomb and bear down especially hard on any red-flag items. "I have found some instances of items around the debt issue or other liabilities that have prompted me to ask more questions and discover some unexpected revelations," says Mr. Vasnetsov. "Unfor-tunately, companies are actually saying less these days," he says. "They're less willing to comment on their outlook. It's sort of had an inverse effect on openness or communicativeness."
Merrill Lynch analyst Karen Gilsenan also relies on the enterprise value (EV) to EBITDA ratio, as well as the simple P/E ratio. "We're increasingly looking at FCF yield-FCF per share to stock price," she says. "Other measures we track include price to cash flow; price to sales; [and] price to book value." She acknowledges that events of recent years "have caused everyone to be more cash focused in their analysis. Cash is cash; cash is king." Particular accounting changes, such as the proposed treatment for pensions and options, have garnered a good deal of attention. "Everybody's scrutinizing balance sheets a lot more closely," she says. The fundamentals of the company, she maintains, "will determine what the appropriate valuation should be, before overlaying the valuation tools." Believing one can never look at valuation by itself, she states it plainly, "Companies with lousy earnings growth, lousy cash flow, lousy balance sheets might look cheap on some valuation metrics, but you're not really going to give them a lot of credit."
Qualitative factors, for her, must first past muster before metrics can come into play. "Is the company innovative? How big is their market share? Are they in growing markets? Is management good? On and on and on." It's the answers to these questions that provide the context or framework in which to view the metrics valuation.
By nature and by conviction, some analysts eschew relying on a single metric. Buckingham Research Group senior vice president and analyst John Roberts, advises clients not to focus on one metric. "One of the things that gets people in trouble in evaluating chemical stocks is that they focus on either price-to-peak earnings, or discounted cash flow, or the near-term earnings outlook," he says. He thinks it is important to step back and take more of a composite look. His approach is to identify companies that both have relatively good fundamentals and are relatively inexpensive on a number of metrics. "We typically don't go for stocks that are outstanding in just one or two areas," he notes. He has developed a chart that, on the vertical axis, plots companies on a relative composite valuation basis, and on the horizontal axis on a relative composite fundamental performance basis. "We can factor in debt-to-capital and interest coverage ratio on the horizontal line," he says. "A company that is highly leveraged would have to be very strong on other metrics, such as earnings growth or free cash flow to offset the leverage requirements."
An economic value added (EVA) metric, calculated as NOPAT (net operating profit after taxes) minus (capital times the cost of capital), was developed by Stern Stewart & Company. Using an EVA system, firms are lumped into two categories: wealth creators (return on invested capital exceeds cost of capital) and wealth destroyers or wasters-those that lose market value because the weighted-average cost of debt and equity capital (WACC) exceeds net operating profit, even though, isolated by itself, the cost of debt financing might be covered.
To convert traditional accounting based figures of EPS (earnings per share) and ROE (return on equity) to an economic value-added (EVA) system could necessitate literally scores of accounting adjustments, many of which are arbitrary but not insignificant in their potential impact. The ROC (return on capital) ratio is disparately affected by methods of accounting versus "economic" treatment of items such as depreciation and intangibles (R&D, goodwill from mergers and acquisitions, deferred taxes, and inventory and other reserves). The accounting emphasis on depreciation versus the "economic" concept of obsolescence can affect the net profit figure of the numerator, while the denominator is affected by whether you use the net fixed assets figure on the balance sheet or the economic notion of replacement cost.
The merit of going to a cash flow metric is in part to circumvent all the deductibility quirks that have arisen in recent years-pro forma, for example, becoming a grab bag not just for the "as if" treatment of merged firms, but as a place to hide so-called unusual, non-recurring or non-operating losses. Capitalizing software expenses, setting up a variety of reserves, and deferring revenue and expenses get flushed out in a true cash flow analysis. Certain kinds of assets, lacking a mark-to-market reflection, can also be grossly understated or overvalued on the balance sheet. These are but a few of the distortions that have crept into and at times threatened to overwhelm the domain of financial reporting.
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