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I previously had the opportunity to introduce my theory of Cumulative Owners Earnings (COE) and I used AAR Corp (NYSE:AIR) for my analysis.

Now I would like to take my analysis to the next step and introduce my theory of CapFlow. Basically CapFlow is the name I have given to the ratio (Capital Expenditures/Cash Flow). CapFlow allows us to see how much capital spending a company must employ in relation to its cash flow, in order to grow the company . This is important because the lower the capital expenditures are, the greater the Owners Earnings (OE) are, as long as Cash Flow continues to grow. Since our ultimate goal is to grow Cumulative Owners Earnings at the fastest rate possible, an ideal situation would be to find a company that is growing its cash flow at a increasing rate while at the same time it is decreasing its capital spending or capital expenditures.

This theory is extremely useful as it is both a qualitative and quantitative ratio in that it acts as a laser beam into the inner workings of a company. Quite simply if a company is increasing its profits and doing so by spending less money, it should, in theory, outperform. When you can have such an occurrence for more than a few years in a row, then it clearly shows that you have a wonderful management in place, that know what they are doing. The following is the same table I put up in the previous post but with the inclusion of a new column called CapFlow;


In the previous post I showed that I was able to buy AAR Corp. for my clients at a 3/4 discount to its COE and at about 6.5 times its OE. But if you go to the table above (yellow part) you will notice the CapFlow percentage figures for AAR have been outstanding. At the same time Cash flow went from $0.58 cents a share in 2003 to $3.12 in 2009, which equates to a 32% average growth rate for those 6 years. At the same time, Capital Expenditures went from $0.31 in 2003 to $0.71 in 2009, which amounts to a growth rate of 14,8%. Therefore as a result, OE went from $0.27 in 2003 to $2.41 in 2009, for an average growth rate of 44% per year. The historical average CapFlow for AAR is 41%, so we came in at almost half that in 2009.

On Wall Street, Mr. Market priced AAR in 2003 at a low price of $3.8 which gave you a 0.25 price to COE, which was the steal of the century. The stock then proceeded to climb to $39.40 in 2007 and traded at 30 times its owners earnings. 30 is the target we like to use as our sell price. From $39.40 it fell to $9.70 in 2008 and again it ended up at 6 times its OE and 0.50 times its COE. So basically history has repeated itself. Had you bought it then, you would have seen the stock go up to a high price of $28.61. So as you can see Mr. Market is obviously ready for the rubber room as the company on Main Street had a stellar performance but on Wall Street was given a roller coaster ride.

During market panics opportunities arise and it is important to know what you own and what the true value of the company is. I do not like to hold stocks that are trading at 30 times their OE or more because the stock market is like a casino for most and when I have a large amount of profit and a stock hits my trigger, I do the smart thing and move on and wait for another day. This is not an exact science but selling at 30 times OE has saved me more times than hurt me.

If you look at the year 1999 in my Microsoft (NASDAQ:MSFT) blog post, you will notice in that year that Microsoft had an owners earnings of $0.72 and was selling for $58.375, or 81 times its OE. At that price it was also selling for 21 times its COE, which is insane. Now we are some 12 years out and anyone who bought the stock in 1999 is still 50% down on it.

It was not Microsoft's fault but Mr. Market's. Microsoft has grown its business on Main Street at a 22.4% average annual growth rate of OE for the last 25 years, but unfortunately those who bought it for $58.375 a share in 1999 paid the equivalent of $500,000 for a Toyota (NYSE:TM) Prius, but since they did not know the value of what they were buying they got taken. Only in the stock market and maybe the Real estate market do investors make these types of mistakes. No one in their right mind would pay $500,000 for a Prius, but in the stock market they do so every day. Buying an Index is no better, because when you buy the S&P 500 you are buying 500 stocks that you have no idea what the value of each is. But that's a story for another day.

Disclosure: Long AIR, MSFT No Position in TM

Source: Profiting From CapFlow: AAR, Microsoft