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Peter George Psaras, has been investing for over 40 years and has expertise in the following: 1) Quantitative Analysis 2) Qualitative Analysis 3) Macro Economic Analysis 4) Technical Analysis 5) Stock Market History He is the CEO at Conservative Equity Investment Advisors, a registered... More
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  • Apple: Analyzing It Using Owner Earnings And Free Cash Flow

    On February 27, 1987 Mr. Warren Buffett introduced in the Appendix of Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) 1986 Annual Report section the following:

    "If we think through these questions, we can gain some insights about what may be called "owner earnings." These represent (NYSE:A) reported earnings plus (NYSE:B) depreciation, depletion, amortization, and certain other non-cash charges such as Company N's items (1) and (4) less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c). However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.) Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since(c) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes - both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes's observation: "I would rather be vaguely right than precisely wrong.""

    In that statement Mr. Buffett also points out that "Our owner-earnings equation" and that "we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes - both for investors in buying stocks and for managers in buying entire businesses.", we obviously can only conclude that both Mr. Buffett and his partner Mr. Charlie Munger use this owner earnings equation in selecting stocks and in buying entire businesses.

    Recently I signed up as a subscriber to a very interesting financial website called Old School Value and the reason I did so is because the founder and fellow Seeking Alpha contributor Mr. Jae Jun has created an amazing software program that makes my work as an analyst and investor much easier. I say that because Mr. Jun's software automatically imports 10 years of financial data from a dedicated professional data feed, but unlike other data providers actually crunches the numbers for you using a multitude of ratio's and formula's. All that is great but the main reason I signed up for Old School Value is because it automatically calculates the owner earnings equation that I talked about in my opening paragraph.

    Since the Old School Value Analyzer Software runs on a Microsoft (NASDAQ:MSFT) Excel format, I am also able to incorporate my work into Mr. Jun's software and then just type a ticker into the dashboard and I get the results I want in about 5 seconds automatically calculated for me. Not only that but I can also incorporate my Excel charts into his software and have them produced automatically for me as well.

    My goal in writing for Seeking Alpha has always been to try to teach as many investors as I can how to analyze stocks properly and in teaching about Mr. Buffett's owner earnings ratio I have chosen to analyze Apple Inc. (NASDAQ:AAPL) for everyone as many investors who read Seeking Alpha own it.

    Mr. Jun's OSV Analyzer calculates owner earnings in the following way:

    Owner Earnings =

    Net Income

    + depreciation, amortization

    +/- other non cash charges

    - (NYSE:C) annual maintenance capex (or the full capex)

    +/- changes in working capital

    The owner earnings interpretation above is the best I have seen and is similar to the one I have been using for years. Not only that but Mr. Jun actually details its components and shows where each came from in Mr. Buffett's statement above.

    Before I show you Apple's owner earnings, let me first also define what free cash flow is as we will be comparing Apple's free cash flow to its owner earnings as part of this demonstration.

    The standard free cash flow analysis commonly used today is calculated in this way:

    Free Cash Flow = Cash Flow from Operations - Capital Expenditures

    So now that we have explained how each is calculated let us now analyze Apple Inc.

    Let us first begin by displaying the data for each equation:


    Followed by a chart representing the data above:

    (click to enlarge)

    I always like to view comparative data on a per share basis, so here is a table displaying Apple's diluted shares outstanding for each of the years in question. I always use diluted shares outstanding as it gives me a complete representation of all shares outstanding as the following definition will show.

    Diluted Shares Outstanding = weighted average shares + shares from conversion of convertible preferred shares + shares from conversion of convertible debt + shares issuable from stock options.

    Now that we have Apple's diluted shares outstanding, we can thus calculate the per share data for its free cash flow and owner earnings.

    Followed by a chart representing the data above:

    (click to enlarge)

    Some years ago I did a backtest on the power of free cash flow in the investment process, which you can download by going to the following link towards the middle of my home page named Price to Free Cash Flow Backtest 1950-2009. In that analysis I went back to 1950 and analyzed the Dow Jones Industrial Average (NYSEARCA:DIA) components over 60 years on a price to free cash flow basis and the conclusion I came to was that when an investor bought a stock at 15 times or less its price to free cash flow or owner earnings, that said investor increased her chances of success dramatically. Therefore when looking at stocks to buy I always multiply the per share data by 15 and try to find points of entry below that price point. The following is the price history of Apple vs. its owner earnings and free cash flow per share data multiplied by 15.

    (click to enlarge)

    Followed by the data that was used to create the chart above:

    (click to enlarge)

    Obviously using the system above explains a lot as to why Apple has been such an incredible investment for those who invested in it. Going forward I believe that Apple is still undervalued and thus I own it for my clients.

    The secret to Apple's success comes from the fact that the company makes products that people love to own, but more importantly management understands that the company is also in business to make profits and will only come out with products that have strong profit margins. One of the major downfalls that led to the demise of Nokia (NYSE:NOK), who was a pioneer in smartphones years before the first iPhone came out, was that management dropped the ball as it had an obsession with market share instead of concentrating on profit margins.

    When you add in amazing design with giving the customer what they want or need, Apple can keep margins high and since they operate now through "Economies of Scale", the more product the company sells the cheaper in becomes (per unit sold) to produce and thus management is able to improve profit margins. Market share is good to have, but without strong profit margins, market share cannot be sustained as you don't generate the necessary profits to allow the company to grow. Apple also continues to produce incredible increases in free cash flow and is expected to produce $64.5 billion in free cash flow for 2015 (when one analyzes it from a trailing twelve month perspective).

    Despite the fact that I have been a skeptic for a while, as I could not believe that the company, with a $732 billion market capitalization, could sustain its growth rate and thus felt it had limited upside. I was proven wrong and thus I have repurchased Apple stock as the latest announcement that the company would return $200 billion to shareholders, changed my mind. I now believe that Apple could at a minimum be the first company to hit the $1 trillion market capitalization mark. I will re-evaluate it when it does so, but as for now Apple is a keeper as long as the company continues to concentrate on profit margins.

    Jun 15 1:31 PM | Link | 3 Comments
  • Introducing The Free Flow Ratio

    The following is my Free Flow Ratio defined using Y-Charts titles. It is basically taking what I believe to be the most powerful three ratio's around and combining them to form a more perfect result.

    FREE FLOW = (Free cash flow to equity + Owner's Cash Profits + Free Cash Flow)/3

    For example for Apple (NASDAQ:AAPL) would have a trailing twelve month Free Flow Ratio result in $billions of:

    ( $40.29 + $59.73 +$62.32 )/3 = $54.11 Billion

    Market Capitalization = $745.58 Billion

    Price to Free Flow = 13.77

    Bargain for the:

    Conservative Investor = any result less than 10 but greater than zero.

    Aggressive Investor = any result less than 15 but greater than zero.


    This is a measure of how much cash can be paid to the equity shareholders of the company after all expenses, reinvestment and debt repayment.

    Calculated as: FCFE = Net Income - Net Capital Expenditure - Change in Net Working Capital + New Debt - Debt Repayment

    Read more:


    Owners' Cash Profits (OCP) = Cash Flow from Operations - [Estimate of Maintenance Capital Expenditures]

    or the long version:

    Owners' Cash Profits (OCP) = [Net Income + depreciation & amortization +/- one-time adjustments +/- working capital] - [Estimate of Maintenance Capital Expenditures]

    Read More

    FREE CASH FLOW Definition

    Free cash flow is the amount of cash generated by a business that is available for distribution among its security holders. Security holders include debt holders, equity holders, preferred stock holders, and convertible security holders. Specifically, free cash flow is used to pay dividends, make acquisitions, develop new products, invest in new property, plant and equipment, pay interest expenses, and reduce debt.

    According to many investors, free cash flow is the best indication of a company's ability to generate cash.


    Net Income
    + Depreciation/Amortization + (Interest Expense - Interest Income) * (1 - Tax Rate)
    - Changes in Working Capital
    - Capital expenditure
    = Free Cash Flow

    Note: YCharts uses the formula Free Cash Flow = Net Cash From Operating Activities - Capital Expenditures.

    Read More:


    Formula = Free Flow/Invested Capital

    Apple FFROIC = $54.11/$146.84 =36.84%

    Anything above 20% is Excellent

    Is used to determine how much in free flow does Apple generate for every dollar of Invested Capital it employs.


    Invested Capital is the total cash investment that company stakeholders have invested into the capital. This is inclusive of equity and debt holders of the company.


    Current and Non-Current Portion of Debt + Shareholders Equity + Minority Interests

    Read More =

    Tags: AAPL
    Apr 07 9:44 AM | Link | 2 Comments
  • Forget About NetFlix & Amazon, This Stock Is The FCF King In The Space.

    Last week I completed my analysis of Outerwall and bought some shares for my Clients. Outerwall (NASDAQ:OUTR) has been in the news lately because on January 20, 2015 its CEO J. Scott Di Valerio stepped down suddenly and as a result Outerwall's stock price fell by as much as -19.51% in one day. When something like that happens I get very interested as I am a bargain hunter and am always looking to capitalize on Wall Street's mistakes. So I started analyzing the company and once completed I waited for the company to release its earnings.

    On February 5th it did so and I was quite pleased as the CEO's departure was not due to potentially poor results on Main Street as I had expected, but was just a disagreement between the former CEO and the Board of Directors as to the future direction of the company.

    Outerwall beats by $0.07, beats on revenue

    Feb 5 2015, 16:02 ET | About: Outerwall Inc. (OUTR) | By: Mohit Manghnani, SA News Editor

    • Outerwall (NASDAQ:): Q4 EPS of $2.44 beats by $0.07.
    • Revenue of $600.6M (+1.2% Y/Y) beats by $0.74M.
    • Press Release

    In Outerwall's conference call Interim CEO Nora M. Denzel said the following:

    We have a deep bench of talented and dedicated employees in place. And today, we benefit from a very strong foundation. We have leading brands with strong consumer engagement, solid relationships with our retail and studio partners and a sound financial position. The board appreciates all that Scott did to get us to this point. Outerwall's business is evolving and the challenges we now face is how to best capitalize on our assets to ensure that the returns we have delivered in the past will continue in the future. The board and I believe in Outerwall, and we have confidence in its long-term outlook. The board decided a new CEO would provide new perspectives, which will be beneficial to ensure that we successfully move the company forward and build on the assets in order to continue the track record we've delivered in the past. Regarding the CEO search, it's a top priority for the board. It's being conducted expeditiously without sacrificing quality. I'm confident that we'll select the right CEO with the right qualities to lead Outerwall. We'll be looking for an experienced executive with a strong consumer expertise and a proven track record.

    The company does not seem in a rush to find a new CEO as Ms. Denzel seems more than capable of running the company until a new CEO is selected. I welcome everyone to read the conference call as it shows a very confident and capable Board of Directors that are making tough decisions to move the company forward.

    So with that concern out of the way let us start this analysis with some key statistics of the company's Redbox business.

    (click to enlarge)

    Source: StatisticBrain

    The research above is from September 22, 2013, but from what I have been able to dig up as part of my own due diligence, most of the numbers above still seem to be valid. The company has decided to close down its Canadian Redbox locations as the business model was not getting much traction there, but otherwise I believe that the Redbox market share in the physical DVD market is still near the 47.8% number (if not more) as its main competitor Netflix (NASDAQ:NFLX) is concentrating more of its attention to streaming.

    Outerwall, despite what many people think is not a one trick pony but also has the very profitable Coinstar program that allows consumers to bring in their jars of loose change and then have the Coinstar machines count that change and give them cash.

    (click to enlarge)

    This may not sound like much of a business, but according to the company's annual 10-K filing its Coinstar kiosks generated $315.6 million in revenue with an average transaction size of $42.12.

    Outerwall's newest venture that it began a few years ago is ecoATM, which provides an automated self-service kiosk where consumers can recycle mobile devices (smartphones, tablets and mp3 players) for cash and generates revenue through the sale of devices collected at its kiosks to third parties. The company is investing a large chunk of its cash flow in building out this venture and has built out 1,890 kiosks in 42 states to date.

    The company issued the following strategy on why management is so excited about the business.

    A survey from ecoATM found that less than half (49 percent) of Americans have sold, recycled or given their old smartphones to someone else after they are done using it. This lack of phone recycling and reuse leaves countless devices cluttering drawers and closets in American homes, or finding their way into landfills, contributing to the growing e-waste problem.

    "ecoATM provides a convenient recycling option for consumers as e-waste continues to grow at a staggering rate," said Kate Pearce, head of mobility research and sr. strategist at Compass Intelligence. "While the collection of four million devices is an impressive milestone, we expect that by the end of 2015 there will be nearly 425 million idle or inactive mobile devices in the U.S., and of those, only about 100 million will be recycled - a relatively small percentage that we hope will continue to increase with smart solutions such as ecoATM."

    While many investors are attracted to Netflix as an investment, due to its strong subscriber growth and ambitious global streaming expansion plans, they also love Amazon's (NASDAQ:AMZN) prime service, which gives them some wonderful content for $99 a year. Unfortunately for these investors the free cash flow numbers for all three companies tell a very different story.

    (click to enlarge)

    For those new to the ratios in the table above here is a small introduction as to how each is calculated.


    CapFlow is the name I have given to the ratio (Capital Expenditures/Cash Flow). CapFlow allows us to see how much capital spending (or capital expenditures, CAPEX) a company must employ in relation to its cash flow to maintain itself and more importantly grow the company. This ratio 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 relative to its growth in cash flow, it should, in theory, outperform on Main Street. When you can have such an occurrence for more than a few years in a row, it clearly shows you have a wonderful management in place that knows what it is doing.

    The ideal again is to consistently have a CapFlow of less than 33% and avoid any company, like the plague, that has a CapFlow of over 100%, as in such a case Management is spending more in capital expenditures than they are bringing in from cash flow from operations. That is a recipe for disaster in my opinion. Just using this ratio alone will narrow your list of potential candidates for investment substantially and will give you an easy to use tool for judging management effectiveness.


    FROIC = Free Cash Flow Return on Invested Capital

    FROIC= Free cash flow/ (long term debt + shareholders equity)

    FROIC basically tells us how much return in free cash flow a company generates for every one dollar of "Total Capital" it employs. I consider FROIC the primary determining factor in identifying growth companies as one can compare every company on an equal basis using this ratio.

    The question I ask every company I analyze is:

    How much return (in percent) in free cash flow are you going to give us for every dollar of total capital you invest?

    A FROIC of 20% or more is considered excellent and the higher the result the better. Since long-term debt is included in the invested capital part of the equation, one can see quite clearly by using this ratio, on just how well or how poorly Management is managing its debt.


    Free Cash Flow Yield = Free Cash Flow per Share/ Market Price per Share

    Free cash flow yield is the amount of free cash flow a company generates on Main Street divided by what Wall Street thinks the company is worth at any given moment. So, basically once you learn this simple tool, you won't care much what others think about a stock anymore as you yourself will have gone a long way in determining just how powerful a stock is relative to its stock market price and whether its stock price is justified, way overvalued or undervalued.

    Having used the Free Cash Flow Yield a zillion times over the years, I have come up with these conservative parameters for my own investing.


    Finally, we come to the final score for any company under analysis and this is done by combining the three ratio final results into one analysis, we grade each company with either a passing score of 1 or a failing score of 0 per ratio where a perfect final score per stock would be a 3.

    The ideal CapFlow results are anything less than 33%.

    The ideal FROIC score is any result above 20%.

    The ideal Free Cash Flow Yield is anything over 10%.

    So, in analyzing Apple (NASDAQ:AAPL) for example, we get for TTM (trailing twelve months),

    For the Conservative Investor:


    FROIC = 34% PASSED


    SCORECARD SCORE = 2 (Out of possible 3)

    Outerwall actually makes $205 million in free cash flow (low end of 2015 projection by management) and sells on the stock market for $1.2 billion while Netflix has a negative free cash flow of $-128 million and sells for $27.5 billion. Amazon generated $1.9 billion in free cash flow or 10 times what Outerwall did but also sells for 145 times what Outerwall does. So to equate Amazons price and free cash flow to Outerwall's, Amazon would need to sell for $42.19 a share, but actually sells for $375.14 a share on the stock market and Netflix, which is losing money from a free cash flow point of view is actually selling for 23 times what Outerwall is selling for.

    Last week I went and did a little experiment on my own to test out Redbox vs. Netflix/Amazon. Now people see these Redbox machines in front of their convenience stores, gas stations and supermarkets, but the first thing I heard from my clients after I suggested the stock to them is that "I never see anyone using them". But people do, as Redbox rents out 1700 disks every minute, as the Statistics Brain research above shows.

    So obviously people still rent disks. But how long is that going to last when you have Netflix, Amazon and Huluplus having streaming services? Well I hate to break the news to everyone, but there are millions of people in this country that cannot afford the $50-$100 a month for internet service/cable, so they cannot benefit from these streaming services, but what they can do is go and rent a movie for $1.20 a night from a Redbox or rent a Disney family movie for the same price and have the family of four enjoy a wonderful evening. (Bluray $1.50)

    I went out to try out the service as I needed to go to the supermarket anyways. So I went to the Redbox, swiped my credit card for $1.20 and rented this movie:

    A Walk Among The Tombstones

    I paid $1.20 and did not need to return it until 9PM the next day

    Now I checked Netflix and the movie is not available for streaming, but is available for DVD rental, but it takes two to three days to get it in the mail. But with Redbox I can just walk across the street and get it from my local Redbox Kiosk. Netflix charges $107.88 a year for streaming and another $107.88 for DVD rentals so you would have to pay $107.88 to get this DVD sent to you in three days. For that same price you can rent 90 movies a year from Redbox. if you also subscribe to the Netflix streaming service as well that number jumps to 180 movies. So obviously Redbox is very competitive.

    Now what about Amazon?

    Amazon Prime is $99 a year but when you want to watch the movie above this is what you see on Amazon.

    So you can stream the same movie but you need to pay $5.99 to do so vs. $1.20 for Redbox. As you can see there is a big difference there.

    So when it comes to newer releases Redbox has its niche and dominates that space, so it will not be going away anytime soon. For the costumer, Netflix streaming service is the dominant player along with Amazon, but when it comes to DVD's Outerwall still seems to be the top dog. Redbox is still very popular and allows those who just have a TV and DVD player a chance to get the latest releases at extremely low prices. With the current costs associated of taking a family of four to the mall for a Disney movie, for those who are patient and wait one could enjoy the same movie at home for about $1.50. I rented the movie above and then had an offer to rent a second one for $.50 cents additional, so I did so. I see this as a tremendous bargain both on Main Street and Wall Street as the company seems to me to be very shareholder friendly as it plans to return a great majority of its cash flow back to shareholders in the form of stock buybacks. I welcome everyone reading this to go and rent a movie from your local Redbox and see if you see what I see. I for one was very impressed and see the stock as an incredible bargain going forward.

    Feb 17 6:27 PM | Link | 11 Comments
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