Stock investing criteria

Stock Investor Criteria

Does the business have the ability to increase the prices of its products and not loose customers

Following companies have pricing power
Blood testing equipment maker Immucor
Luxury goods mfg Louis Vuitton
Ice cream mfg Haagen Dazs
In contrast commodity type businesses like Steel producers do not have pricing power
Common characteristics of firms with Pricing power
Have high customer retention rates
Business with a high renewal rate on its services typically has pricing power

Low Price Sensitivity
The higher the % of the customers budger spent on a product/service, the more likely the customer will be price sensitive
Medical laboratory testing business have pricing power because their cost to the customer represents 3% of overall medical spending

Customers have profitable Business Models
If customers have plenty of cash or their businesses are highly profitable, they will be less sensitive to pricing
Bloombergs customers are mostly traders who have a high profitable business
High quality products/services
Sometimes the quality of the product is more important to the purchaser than the price
Jet engine mfg use Precision castparts castings, parts to manufacture Jet engine for aircrafts. These are very critical parts.
Keep an eye out of important pricing power indicators
Multiple years of increase
Pricing higher than competitors
Increases that don’t offset costs
Check if increase in price results in additional revenue
Check if increase is lasting or not
Check if price increases is translated to operating income growth or if they are used to offset expenses
Another method to identify pricing power is to calculate historical operating profit metrics
If a business has pricing power, it will disclose the increase in prices.
Whether Pricing power is found through the overall business or only a segment of the business
Some businesses have pricing power in certain products/services.
Airlines have pricing power only on certain routes where there is less competition
Indian airlines flight from Mumbai to Belgaum

Technology creates Transparency
Internet creates Price transparency especially in Hotel room rates

12 What pain does the business alleviate for the customer
A medical disposal company avoid potential liabilities that come from disposal of medical syringes

13 To what degree is the customer dependent on the product or services from the business
Need to have
Company which manufacturers heart pacemakers
Need to have but not immediately
Example?Car Maintenance
Need to have but not critical
Travel, New car, New house

14 If the business dissapeared tomorrow, what impact would it have on the customer base
Ask what a customer will do if the busines dissapeared tomorrow

15 Does a business have a sustainable competitive advantage and what is its source
How easily can someone copy or replace this advantage
How quickly might they do it

A business with reinvestment opportunities inside the moat has much higher intrinsic value
than a business without competitive reinvestment opportunities

Cash from other businesses can be reinvested in the core business

Common source of competitive advantages
Network economics
Many people using it
Facebook
Timeshare exchange

Examples of an expanding advantage
Western union money transfer has been increasing locations all over the world
Examples of a deteriorating advantage

Diners Club stuck to a charge card whereas others offered free card offering credi
Diners Club ceased to become the market leader

Brand loyalty
Customers remain loyal to the brand
Business can charge a premium for the brand
Example:
Four seasons hotels can charge a higher rate for its hotels in return for an unrivaled service
Starbucks is best known for supplying premium coffee in an inviting atmosphere

Bad signs
Management cut development,marketing and promotion to save expenses
Mangement will discount the price of its products in order to sell excess inventory
Gucci discount price frequently
Louis Vuitton never offers discounts
Tommy Hilfiger diluted its brand by offering discounts

Patents
Patents are a source of protection because they legally protect the products, services of a business from its competitors
Need to understand the commercial value of the patent as evidenced by any product or licensing revenues
Pharmaceutical patents are easy to research and understand
Technology patents are difficult to research and understand
However Patents have a finite life and one needs to be cautious not to assign too much value to them

Regulatory licenses
Regulatory licenses and approvals can create an advantage by limiting competition
Western union money transfer benefits from laws inhibiting money laundering
If Regulatory entity controls the prices a business can charge to the customers, then the competitive advantage is weaker
Regional casino is regulated by each state in which they operate

Switching costs
The higher the switching costs, the less the chances the customers will switch to competitors
Bloombergs financial services and products requires a lot of training. Hence there is a lesser chance of switching to competitors

Cost advantages
Includes factors like Economies of Sales, Advantageous locations
Lowering costs by moving a call center to India
Obtain a Cost Advantage through Industry consolidation
Business which acquire other businesses to achieve economies of scale & thereby reducing the price of their products
LabCorp, Quest reduce the cost of their products by acquiring other businesses
Obtain a Cost Advantage through a good location
When a business has a location that competitors are unable to duplicate, this gives the business a cost advantage
Example: Cement plant in certain areas of USA
Expensive for competitors to build a new cement plant + also inefficient to ship over long distances because of its weight
Best kind of sustainable competitive advantage is Structural
When customers have limited choices in the products, services they can use, advantage is structural
Example: There are only 2 companies manufacturing Infant formuls (Enfamil, Similac are the only 2 products)
It is very hard to have a sustainable competitive advantage over a long period of time

Consumers are less loyal to products or brand names
Increased global competition has lowered the bar for new entrants in most industries such as manufacturing
Technological advances have shortened the lifecycle of many competitive advantages
Amazon benefitted from Technological changes. Barnes and Nobles suffered as a result of Technological changes.
Newspapers lost the classified advertisers to low cost internet sites
Beware of Businesses which were simply at the right place at the right time
When the prices of computers dropped, Dell was able to beat its competitors on price because it had the lowest cost structure

Most investment gains are made during the development phase, Not after
Best way to distinguish whether a business is building a competitive advantage is to monitor the number of customer it is serving

Look for companies which push products or services innovations by investing in R&D or wisely spending in Marketing to increase awareness of product
Example: Apple continued to spend on R&D even after its revenue dropped by 33%

What is a good sustainable competitive advantage
Good customer service, Quality product, Very Knowledgeable work force, returns calls within an hour is preferable, Strong employee culture, Efficient production process

17 Does the business operate in a good/bad industry
Investing in the right industry is very important because the large rate of your potential rate of return is often attributable to the industry you are invested

Calculate the Range of Industry Rteturn on Invested Capital
Calculate the Return on Invested Capital (ROIC)
Pharmaceutical industry has a ROIC of 13-21% over the last 10 years
The best pharmaceutical industry is not far from the worst
Oil companies has a ROIC of 3-15
Lister believes that finding the right industry is what counts
If you pick up a stock from an industry growing between 5-8%/year, even if you do not identify a good stock, the chances of your stock doing well are high
Some of Lister’a 100 scorecard are as follows

What drives the industry

How do people compete within the industry

What is the larger macro picture

What are the industry trends

What is the average cash conversion cycle for this industry

What is the industry’s exposure to cyclical markets

Does the industry have the ability to pass on price increases

What is the Volatility of demand from the customer
Lister’s analysis as to why ASSOCIATE FREEZERS company was a good buy
Underlying demand was strong
As women entered the workforce, frozen foods were large part of the diet
Quality of frozen foods increased
Customers (Frozen food mfg) chose warehouses based on service, real time links to inventory, good temperature control,quality,on-time delivery rather than price
There were barriers to entry by capital as capital expenses was high
Special expertise was required (staff engineers) were required to handle the dangerous equipment
EBITDA margins exceeded 36% once a refrigerator warehouse was built
Average cash conversion cycle was 120 days so refrigerated warehouses could grow without a lot of borrowed cash

18 How has the industry evolved over time
Refer to S&P Industry Surveys on many industries. Report are broken down into sections on how the Industry operates, Industry trends, Key Industry ratios and

Statistics

19 What is the Competitive landscape, and how intense is the competition
Does the business have limited competition
More competition more customer service and less profitability
Comtetition does not increase the value of he businesst

A buinsess with limited competition is easier to analyze than one with a lot of competition

Does the industry change often
If the industry changes constantly, then it will be more difficult to evaluate the competitive position of a business
Example: Technology business-> Business might change by the time you have finished analyzing the competetion
How does the competitors compete within the industry and how that can change
Competing on Capital
If the business competes on Capital, then the advantage will always reside with well funded companies
Example: BHP Billiton which has more capital has an advantage over small mining companies and thus develops larger mines
Competing on Service

Company with a stronger, more ingrained customer service will have an advantage

Competing on Price
If the competitors in an industry have to constantly match each other based on price, the business may have a difficult time
increasing its margins or prices, as increase in margins will need to come from cost cuts which become difficult to achieve

Competing by copying
There is a risk when competitors attempt to meet a competitor head on by entering the same business line where the competitor has an advantage
Merrill Lynch tried to copy products in derivatives trading which were the profitable products of Goldman Sacs. However this staterfy destroyed his M.Lynch

How fiercely does the business compete

Can depend on whether the competitors are rough;y equal in size, then it will be intense competition
Example: Cash checking industry
For industries with only a few strong players controlling the market, these market holds an advantage simply because of their size
Sometimes companies competing on Price loose their volumes since the consumer is used to lower prices and reduces consumption
Coke and Pepsi war
When Blockbuster increased its price, irt quickly lost the advantage to Netflix
Tracking Operating cost/customer OR Operating cost/transaction are important points
These costs tend to increase in a highly competitive market
What Risks does the business face from Substitute Products
Email is a substitute for Mail
Plastic is a substitute for Aluminium
International calling cards suffered when Skype entered the market
With Advancements in digital photography, Kodak & Fuji lost significant market share
Typically a more Asset intensive business like airplane manufacturer, chemical and cement industries have a longer period of immunity from substitute products

Can Competitors from low costs countries impact the business
Need to determine if the business is threatened by Foreign competition
Generally items that cannot be shipped over long distances are not subject to foreign competition
Example: Rock quarries, Plastic parts for Automobiles since the former is expensive to ship, latter is too delicate to ship

Which Competitor sets the Industry Standard
Make comparisons between various competitors
Locate a business with the
Highest operating margins
Highest return on capital
Lowest Cash conversion cycle
Create a spreadsheet and measure the various Financial and Operating metrics of the competitors

Why have Competitors failed in an Industry
One of the biggest risks in Oil and Gas industry comes from having lax safety standards

20 What type of relationship does the business have with its supplier
Business needs to constantly negotiate lower prices from its suppliers in order to increase earnings

However if they do so, the suppliers will eventually go out of business

Following will help you understand if the business has a good relationship with its suppliers

Does business have reliable sources of supply
If business does not have reliable sources of supply, then it will generate more volatile earnings
Nestle worked with the coffee farmers in poor rural areas by providing them with tools, advice, pesticides, fertilizers

Does business help Suppliers innovate by providing them with customer feedback
Chrysler provided customer feedback to its suppliersto help them develop new features that required fewer repairs and less frequent replacement

Does business depend on only a few suppliers
Need to determine the possible risks if the business depends only on a new few supplier or if a single supplier makes up a huge portion of supplies

Does business depend on commodity resources and to what degree
If it is dependent on commodity resources, need to monitor these prices
Rising commodity prices will force the business to increase the prices
This will reduce the profits if the business cannot pass the prices on to the consumers
On the converse if the commodities price decreases, the business can decrease the price
Example; If you are analyzing apparel makers, need to analyze Cotton prices

21 What are the Fundamentals of the business

Fundamentals are the basic things a business must do in order to be successful

Express delivery company needs to deliver on time

Restaurants have to serve good food

High employee productivity helps Southwest Airlines succeed. That’s how it keep the fares low and increases productivity
Determine whether the management team understands what increases the value of the business and whether that shapes their actions
CEO of Strayer Education focuses on academicquality which drives good student outcomes
CEO Bloomberg focus on giving customers the information they need and in whatever form they need
CEO Amazon focus on delivering orders in a timely manner and offering more products at a reasonable price

You can measure and track each of these like
Food quality/Customer satisfaction/Rate of on-time deliveries/Employee productivity/Graduate employment/Faculty quality

If the fundamentals are deteriorating, then the value of the business will as well
Watch for CEOs who chase too many ideas or having continually changing vision statements
In 2008, Starbucks CEO perused too many things which we not central to their vision. Hence they performed badly
If a negative news causes a drop in the stock price. Always ask “What impact does the announcement have on the fundamentals of the business”

22 What are the Operating Metrics of the business you need to monitor
Monitor whether the Fundamentals of a business are improving or deteriorating is to measure and evaluate the Operating Metrics of a business

Identify the Metrics for a particular industry

Banks use Efficiency ratio, Return on assets, Average cost of funds
Real estate uses Occupancy rate, Rent per square foot, Cost per square foot
Airlines use available seat miles, load factor, traffic and capacity
Retailers use same-store sales, basket size, sales per square foot and average ticket
Internet firms use Conversion rate and traffic counts
Subscription type firms uses number of subscribers, average revenue per subscriber, average cost per subscriber and customer churn
Credit card firms use net charge off, delinquencies and payment rates
Hotels use occupancy, revenue per available room(Revpar) and average daily rate (Adr)

Efficiency Ratios (Used by banks)
Non interest expense/Total Revenue
It is the bank ability to control its expense level
The lower this ratio the better a bank is at controlling expenses
Smaller banks tend to have higher efficiency ratio than larger banks as larger banks tend to generate higher earnings from fees + spread their expenses over many products

Same Store Sales (Used in Retail)
Defined as year-over-year sales change for a store that has been open at least 12-18 months
If the competitor sales are good. However the retailer you are studying has declining same store sales, then the retailer is loosing market share

Key operating metrics for a business are
Number of transactions, customers, locations, employees, total square footage of operating locations.
Revenue per transaction
Cost per transaction
Transactions per location

• Monitor Metrics over a 3-5 year period and not a single year

Determine if changes in Metrics are lasting or temporary
Extreme weather conditions can cause a temporary decrease
Increase competition can cause a permanent decrease
Compare Metrics amongst competitors
Whist comparing, ensure that both businesses are using the same measurement and same accounting standards
Make sure the same time periods are used such as 15 months versus 12 months for same store sales
Finding costs per barrel of oil (Compare between 2 oil companies)-> There are 2 different accounting methods which can be used

23 What are the key risks the business face
Broken down in 2 parts
Risks that relate to the business or the industry
Risks that relate to the stock price
Operational Risks
Overcapacity
Commoditization
Deregulation
Increased power among suppliers
Shifts in technology
Changes in laws and regulations
Product obsolescence
Patent expiration
Development of new product lines where the business has limited expertise
Emergence of competitors
Brand erosion
Overreliance on too few customers
Limited geographical distribution
R&D failure
Business-development failure
Merger or Acquisition failure
Weak product pipeline
And others

• Identify those risks which have the highest impact on the business
  For exmaple if 5 customers account for 70% of the total revenue. If one customer who represents 20% share were to leave,
  what would be the impact
  Just because an event has occurred and the media is constantly discussing about it, it does not mean the actual risk is greate.
  The more the people talk about a risk, the more likely the risk will be mitigated
  Insurance writers always think in terms of frequency
  One value resource which will help you identify the frequency and severity of potential risks is the Insurance m,anuals written for underwriters
  A.M.Best Underwriting guide
  Provides a checklist of 580 commercial and industrial classifications
  Advertising, Beverage, Clothing,Manufacturer etc
  24 How does Inflation affect the business
  Inflation affects most businesses negatively
  Inflation is the value of money going down
  Inflation’s biggest threat to the value of a business comes from the inability of a business to fully pass on cost increases to its customers without loosing sales volumes

Ability to pass along Price increases

Ability to reduce costs
A busniess which has a high fixed-cost structure or the one which needs to constantly reinvest capital in its assets (eg:Refinery) will have a difficult
time decreasing costs to offset the negative effects of Inflation
Low Capital-Expenditure requirements
Business with large capital expenditure, inflation increases the cost of replacing existing assets (Eg: Retailers trying to build a new store)
Long term Debt Maturitoes
Inflation causes borrowing to become moren expensive
Lenders avoid making long term contracts and are more demanding on covenants during inflatory periods
Business which have Long term Debt Maturities or Limited Debt are in a better position as they can avoid both increased interest expenses
and more restrictive loan covenants

Inflation Risks
There are basically 2 types

Wage Inflation
Business with a large number of employees (Eg: Grocery store) will be affected by Wage Inflation
Wage increase can come from several sources
Salary, Benefit packages, high employee-retention rates

Rising interest rates
Most stocks are negatively affected by rising interest rates
The Price to earnings ratio of the stock drops
That is why the stock tends to perform badly during periods when inflation is rising and corporate
earnings are declining

Businesses that invest in real estate would be negatively affected as the capitalization rates in a
rising interest rate scenario increase which would then decrease the overall asset values.
If a company has a lot of variable debt, then rising interest will also increase the interest expense

25 Is the business balance sheet strong or weak

Identifying a Business motivation for Debt

Did the business take on debt to fund losses, make acquisitions,pay special dividends or enter new product lines
Domino Pizza took on debt to pay special one time dividends
Management often attempts to justify that the Balance sheet needs a better capital structure
and needs to leverage maximum value to the business. It is better to stay awa

Considering the advantages of Low Debt
The business has less risk of entering bankruptcy
A strong Balance sheet allows the business to be optimistic. Such businesses gain a competitive edge such as buying back stock, making acquisitions
Eg: Brookfield will only borrow the amount that it would typically to able to pay back in1 business cycle

Determine how much a business can borrow
Depends on factors like Profitability,Stability,Relative size, asset composition and the Industry position of a business
It also depends on external factors such as credit market conditions and trends
The more stable cash flows of the business, the more debt it can take on
Example: A Utility business where cash flows are steady can handle high amounts of debt on its Balance sheet.
Homebuilder cannot handle high amounts of debt

Factoring in Off Balance Sheet Debt
Include
Lease obligations, Warranties, Purchase contracts, Unfunded pension liabilities, any other contractual obligations
These are normally disclosed under the section “Commitment and Contingencies”
Retailers, Ship operators, Airlines and many other type of businesses have large contractual obligations that are off balance sheet
Example: Many businesses rent out buildings and equipment usinh long term lease contracts. If these are classified as

Operating leases
rather than Capital leases, they are not required to be reported on Balance sheet. However these rental payment are considered as Debt.
A good rule of thumb foe estimating a businesses total Lease Obligation is to multiply one years rental expenses by 7
Another example of an off balance sheet liability is when a utility is required to purchase a certain amount of coal per year at a fixed price per ton or
when a lawsuit that is pending and the business has estimated potential liabilities in the form of damages it will be required to pay in the future

Using Ratios to determine a company’s ability to pay its Debts
There are 2 ratios to find out how easily a company can repay its debt

Coverage ratio
Measure the ability of a business to meet fixed obligations
Coverage ratio takes the income available for paying the total fixed obligations for a given year and divides that by the annual interest expense
and fixed charges.

Various types of coverage ratios
EBITDA to interest expense
EBIT to interest expense
Cash flow from operations to interest expense
Example: If a company generates 200million in pretax income and pays 50 million in interest expense, then its interest coverage ratio is 4 times.
This is the number of times the business can cover its interest expense out of pretax income
When calculating coverage ratios, it is advisable to use cash flow for the numerator because liabilities must be paid in cash
Earnings can be manipulated so using cash flow provides a more consistent, dependable measure
Coverage ratio vary from industry to industry
Conservative converage ratio for a healthcare company might be EBITDA/interest expense of 8 times
Conservative converage ratio for a oil and gas company might be EBITDA/interest expense of 10 times
Static ratio
Measure the ability of a business to repay its Debt obligations at one point in time

Current assets to Current Liabilities

Debt to equity

Debt to total assets
For example if you analyzing a Retailer, the ratios will fluctuate depending on the quarter.
In the 1st,2nd quarter, the retailer is stocking up inventory and may have great debt, more assets and generate less earnings
In the 4th quarter, the same retailer may have less debt and assets but generate higher earnings because of holiday sales

Assessing the Short term Financial strength of a business
Need to understand how liquid the balance sheet is
Help u to access the ability of a business to pay its short term liabilities
Short term liquidity is extremely important to lenders because it is the inability to pay short term liabilities that causes more businesses to enter bankruptcy
The assets on the Balance sheet are organized in the order of their liquidity
Current assets such as Cash, ACR and Inventories.
Long term assets include Property, Plant and Equipment
Cash
Many businesses earn their revenues in foreign land and keep cash balances in that country to avoid paying taxes
Sometimes cash is required to build inventory ahead of festive season
Investors should normalize cash amouints to account for these patterns

Accounts Receivable
You need to calculate receivable turnover in order to understand how quickly a business is able to collect on its accounts receivables
For example if it takes 120 days for a business to convert its receivables into cash and it has only 30 days to pay down short term debts,
then the business might face a short term liquidity crunch

Inventory
Understanding how long it takes to convert inventory to cash will also help u understand how quickly a business can pay back
its short term liabilities
You can calculate this by dividing the cost of goods sold by average inventory. Convert this to the number of days it takes to
turn inventory into cash by dividing this turnover figure by 365
Inventory turnover represents one of the main ways that a business generates revenue. Business needs to have enough revenue
else it will result in lost sales
Having too much inventory for long periods is not good either.
In addition to failing to produce revenue, a business would have to pay to store it and it can go bad or become obsolete
Assessing the Long term Liquidity of a business
If you are unable to make long term projections (which is often the case with cyclical businesses), then you will more than likely
be unable to understand the long term financial strength of a business
Brookfield converted debentures which are mid to long term debt, into common shares. This added to permanent quity to
Brookfield’s capital base. It strengthened the balance sheet and eliminated interest cost and risk of these debentures
Thus Brookfield used permanent equity capital instead of short term funds to finance its business
Determining whether the Debt interest interest rate is Fixed or Variable
Determine if the interest rate on the debt is fied or based on variable rates such as LIBOR plus 5%.
If it is fixed, you will be in a better positionto access the impact of debt financing
It it is variable, you must allow for the possibility that interest rates may increase or decrease, adding uncertainty to your projections
Determining the Debt Maturity Schedule
Refinancing Debt is a risk for a business. It is important for you to determine when Debt is coming due.
For example a business may have issued Debt when the interest rates were low. If interest rates rose during that period
and the business intends to refinance its Debt instead of Pay it off, it will have to pay a higher interest rate which will decrease
its earnings of the business

Evaluating Loan Convenants
To understand if the business is financially strained, evaluate its loan covenants and determine if the business is nearing
the loan covenants set by its lenders.
Loan covenants are the terms of the loans that the lender requires and they save to protect the lender.
If the business is nearing the limits of its loan covenants, then it is an indicator that it is financially strained
However being in good shape with respect to loan covenants is no guarantee of solvency,management is
able to stretch the definition of covenants to present a better financial picture
Determine whether the business has recourse or Non recourse Debt
The most benign form of Debt is Non-recourse debt which is the debt that is secured by a particular asset
and not by overall business
In a non-recourse situation, if the business defaults on a loan backed by a certain property, then it has to turn over
the property to the lender without further losses

26 What is the return on invested capital for the business
ROIC is the profit a business generates relative to the amount of money invested in the business.
It shows you how well the business is using its assets
The higher the ROIC, the better the business
ROIC is Income/Investment used to generate that income
A business with a ROIC below 5% is typically considered as a Low quality business
A business with a ROIC above 10% is typically considered as a High quality business
The average ROIC varies from industry to industry
ROIC for Software, soft drinks, pharmaceuticals, distilled spirits, luxury products and medical products
companies have a ROIC > 20%
ROIC for Hotels, packaged foods, grocery stores, drug stores and book publishing have a
ROIC between 10-20%
ROIC for Airliners are from negative to 5%

Why is it important for you to calculate ROIC
Lets say in the 1st business it takes 1 million in capital to earn 100,000
In the 2nd business it takes 10 million in capital to earn 500,000
ROIC in 1st business is 10
ROIC in 2nd business is 5
In the Oil & Gas business EOG Resources Inc, the ROIC has been 20% on average
As a result the Book value increased which in turn caused the Stock price to increase.
ROIC turns out to be a good indicator of stock indicator of stock return over long haul
If you pay fair value for the stock and hold it for 5-15 years, odds are if the ROIC is 5%,
then your return will be similar
You must place ROIC for a business in context with the price you pay for a Stock as
the price determines the rate of return
Make sure you pay a low price for the stock and not multiples of Book value
How to improve ROIC
Using capital more efficiently such as managing inventory or receivables better
Increasing Profit margins, instead of through one time, non operating boosts to cash
earnings

Example: A supermarket chain is content earning a low net profit, typically 1% bcoz
it turns over its inventory very quickly
It has relatively low investments in assets becaused most of its assets are leased

Example: A capital intensive Steel manufacturer has a heavy investment in assets
This results in low asset turnover rates. They must achieve a high net profit margin
in order to offer investors a reasonable return on capital

A business can be more productive with its long term fixed assets. If a business can
generate more sales for each dollar of property,plant and equipment it owns, then
it will be able to generate a higher ROIC.
For Example: A restaurant that wants to increase its ROIC might think about opening
for lunch as well as dinner. This allows the restaurant to generate more sales
per dollaer invested in restaurant assets

A business can use online sales channels to improve efficiencies in inventory and sales
costs while also reaching additional markets.
Ecommerce site for William Sonooma has a lower fixed asset base, higher inventory
turns and a higher operating income margin which causes it to earn a higher ROIC

A business can improve its ROIC through higher inventory turns (Cost of goods sold/Average inventory)
because operating with higher inventory turns requires less capital to finance the business
The more the inventory turns, the faster a business gets back the moneyit has spent
on the inventory
In affect the business has its money invested in inventory for a shorter period of time

A business can collect its accounts receivables from customers faster
Constellation brands focussed on receivables and were able to bring down the number
of days that sales were outstanding (DSO) by 4 days. That was worth 9 million a day
By collecting amounts more quickly, Constellation brands has less capital invested
overall, increasing its ROIC

A retailer can be more selective in the product lines it carries, focussing on those
that sell quickly and removing those that sell slowly
Walmart opened smaller stores and stocked them with fast selling items rather than
wide assortment of items, this improved inventory turnover and thereby increase ROIC

A manufacturing form can use lean manufacturing to cut the inventories it needs
to stock or it can make suppliers responsible for stocking inventories

Why ROIC is less useful

ROIC is less useful when the Investment base does not add to the earnings of the business
This is typically the case in knowledge based businesses such as money management
, information services or non-capital intensive businesses
Example -> If Mutual Fund manager increases the number of desks and computers in his office,
this investment will not add to the returns of the business
Therefore calculating ROIC in firms like this compared to firms that has higher amount of invested
capital is less useful
Example- Praxair a producer of Industrial gases builds new manufacturing plants every year to meet
the demands of its steel mill, glas furnace and chemical plant customers

Do not rely on Historical ROIC when making Forecast
Do not rely too much on Historical ROIC and project it indefinitely into the future without
considering that returns typically decline over time or that a business is limited in the
amount of capital it can redeploy in the business
Very few businesses are able to maintain high ROIC over long period of time
and those that do, often have limited growth prospects
Make sure you are not extrapolating past returns without understanding how the returns are earned
A business may have a new product that has limited competition that allows it to earn
a high ROIC in the early years. If competition enters the market, you may need to
reduce the forecast of ROIC

A retailer may have saturated its growth in the best locations and is now beginning to locate new retail
sites in secondary locations which may not generate the same returns as the older locations. In this
case you will reduce your forecast of future ROIC

Increased regulatory requirements may force a business to reinvest capital in the business that does not
earn return such as when the Environmental Protection agency introduces new regulations which
requires big rig trucks to emit less pollutants. The trucking industry needs to replace the engine which
in turn will decrease ROIC.

Limitations of making comparisons
If u are comparing the ROIC of 2 refineries (one that is older compared to a newer one), the depreciated cost
of the old refinery will generate a higher ROIC compared to the newer one. The newer refinery may be more
efficient and operate at a lower cost, but you would have to adjust the asset value of the old refinery for
inflation to make a more meaningful comparison between the 2 firms

Differences in accounting methods also complicate the ability to make comparisons
If you are comparing 2 firms within the same industry, you have to adjust the accounting statements
of both the businesses to ensure that their accounting methods are consistent
For example you want to make sure that both businesses use the same Inventory accounting method
such as First in First out (FIFO) inventory methods

When comparing a fast growing business to the one that is not growing, you might find that the ROIC
is higher for the business that is not growing. The reason is that in fast growing business,investments
are more weighted to the more recent investment projects such as recent equipment purchases,
new store openings leading to higher Book value denominators thus pulling down ROIC

Businesses that constantly reinvest in their business to build an advantage such as maintaining their property,
plant,equipment or invest in product development,marketing will show a lower ROIC that does that do not.

27 Are the Accounting standards that management uses conservative or liberal
Here are some of the ways to determine whether the management is using liberal or conservative standards

Read the Income tax footnote
A good place to begin learning if a business’s reported earnings approximate its actual earnings is to read
the Income tax footnotes found in the company’s 10-K report
A business keeps 2 sets of books
One is based on GAAP accounting
Other is used to calculate the taxes a business owes to the IRS
IRS is a conservative benchmark since most business seek to minimize their tax return income
On the other hand management can select from various accounting methods to calculate GAAP income
If there is a large difference between earnings from these 2 sets of books, it will be captured in the income-tax footnote
GAAP taxes on earnings (known as Income tax provision)
Amount of tax paid to the IRS (Current taxes)
In the Income tax footnote, compare the differences between the Income tax provision and Current taxes for 5 to 10 years
Calculate how much book earnings are overstated or understated compared to current taxes
If you discover that a business is reporting earnings yet is not paying taxes, this should set off some alarm bells as
businesses rarely cheat the IRS
For example one business reported 189 million in after tax earnings but it paid the IRS and foreign tax authorities only 5 million
This suggests a huge difference in profits reported to the shareholders versus profit reported to IRS

Compare Cash flow from Operations to Net Income
Management has less flexibility in manipulating cash flow from operations than it does net income
If net income closely approximates cash flow from operations, then there is less likelyhood that it is being manipulated
However if net income is consistently higher (more than 30%) than the cash flow from operations, this may be
a sign that the management is manipulating earnings

Evaluating whether the management manipulates earnings
Earnings are most often manipulated to cover up deteriorating earnings within the core business
Other times, management wants to meet the quarterly expectations of Wall street analyst by shifting earnings from good years to bad years
or by shifting future earnings to the present

Look out for any or all of the following

Inflating Sales
Management can book a Sale before revenue is actually earned by incentivizing customers to take more product that they need
This is more likely to occur when the buisiness sells its products through distributors or resellers, when it has few large
customers or when the sales representative wants to hit a quarterly sales number
You can identify methods to accelerate revenues by looking for large increases in account receivable growth compare to
sales growth
When Accounts receivable is growing faster than compared to sales, consider it as a warning sign
If Sales grow by 10%, then the Accounts receivable should also grow by 10%
Example:Sales of Baush & Lomb grew by 12% percent while the receivable grew by 35%. Baush & Lomb changed the way it accounted
for revenue. It previously recognized sales when made to end customer but it changed to recognizing sale to distributor
A sale to the distributor is not the same as the sale to a customer because selling to the distributor does not guarantee the end customer will buy the product
and the distributor can return the unsold goods

Sometimes Receivables growth exceeds Sales growth and this might happen for several reasons
Instead of requiring payment within 30 days of shipment, a business might ask the customer to pay in 45 days
It can be due to the deteriorating creditworthiness amongst existing customers which would represent another problem
A business might change its financial reporting procedures which determine when sales are recognized

Under or over-stating expenses
Management sometimes shifts current expenses to later periods in order to boost short term earnings
Common types of expenses that are capitalized and later depreciated include
Start-up costs
Research and development expenses
Software development
Maintenance costs
Marketing
Customer acquisition costs
AOL in 1994 said that it was classifying market costs as balance sheet assets rather than operating expenses naming them
Deferred Subscription Acquisition Costs. BY Capitalizing these expenses, AOL was able to overstate its earnings for several years

Manipulating Discretionary Costs
Costs which include advertising, R&D expenses and maintenance costs
These costs can be manipulated to smooth expenses
If you discover that in the 4th quarter, R&D expenses dropped by a material amount compared to the same quarter a year ago
this may indicate that the management is attempting to smooth earnings
80% of the financial executives responded that they would reduce spending on discretionary expenses

Changing Accounting Methods
One of the most popular methods to differ expenses is to extend the useful life of assets in order to reduce depreciation expenses.
When the book value of an asset is more than the present value of projected cash flows from the asset, some companies
write down the value down the value of the asset
Management may be tempted to write down the value of the assets during years when the earnings are lean
The effect of writing down the asset is that the depreciation and amortization expenses are also reduced for periods in the future,
causing earnings to automatically increase during future periods

Restructing or One-Time expenses
If a business is reporting a large restructuring loss, management may add extra expenses in that restructuring charge in order to
decrease future expenses. Later management can reverse these restructuring charges to increase future earings.
Typically a Liability is set up by writing off the expected cost of the restructuring as an expense and crediting a restructuring
reserve or other accrued liabilities and oayables account htat is recorded as a liability in the balance sheet
Later as the costs of the restructuring are paid off in cash, the restructuring reserve liability is reduced. If the management
initially overstates the amount of restructuring expenses, it can reverse the liability and add the amount to the earnings
CEO of Sunbeam did several restructuring expenses and reduced net income from 50 million to -228 million
By doing so, Sunbeam was able to move future year expenses to one year’s income (more than 2 times the amount of net income
Sunbeam reported only 2 years ago)

Using Reserves
Reserves are often called the cookie jar of accounting manipulation because they require a large degree of judgement to estimate.
The term cookie jar refers to the ability to artificially store earnings in the balance sheet so that the dishonest management can
draw on them in unprofitable future years and lessen the impact of the negative times on its financial statements.

Reserves can be booked for:
Bad debts
Sales returns
Inventory obsolescence
Warranties
Product liability
Litigation
Environment contingencies