How To Value Your Portfolio On Main Street Vs. Wall Street

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Includes: AAPL, BRK.A, BRK.B, BXUB, BXUC, CRF, DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PPLC, PPSC, PSQ, QID-OLD, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL, RWM, RYARX, RYRSX, SBUS, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPSM, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU-OLD, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TALL, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USA, USSD, USWD, UWM, VFINX, VOO, VTWO, VV, ZLRG
by: Mycroft Friedrich

Summary

Performs a quantitative analysis of the S&P 500 index using some unique free cash flow ratios.

Shows how to analyze your own portfolio in the same way.

Explains the difference between Main Street Analysis vs. Wall Street Analysis.

Allows one to practice “Capital Appreciation through Capital Preservation."

In this article, we will present a real-time quantitative analysis of the S&P 500 Index (NYSEARCA:SPY), which will demonstrate the power of free cash flow in the investment process. In doing so, we will also teach everyone how to analyze one's own portfolio on Main Street vs. Wall Street. Let us begin by analyzing Apple Inc. (NASDAQ:AAPL) and at the same time explain how the methodology involved in this analysis came about.

Main Street is where Apple operates and Wall Street is where its shares trade. The Apple shares that one can purchase on Wall Street are in the public domain and the company has little control over how each share will trade. Apple is required to release its earnings reports each quarter and from time to time it also provides press releases to its shareholders (and the general public) giving updates on how its operations are doing on Main Street.

Main Street is where Apple invests in its own operations, creates products and sells to its customers. How well Tim Cook (CEO of Apple) and management do in selling those products, determines how profitable the company will be. Wall Street then reacts based on the success or failure of management to meet its goals. Main Street and Wall Street are thus interlinked, but because anyone with a computer, an internet connection and a brokerage account can buy or sell any stock at anytime, expertise is not a requirement in order to invest on Wall Street. This results in Wall Street being a very dangerous place to operate in as many investors tend to operate through emotion or tend to follow the herd in and out of stocks. During bull markets, investors feel like they can do no wrong as "the rising tide lifts all boats." But when a bear market suddenly shows up, these same investors tend to panic and like lemmings stampede over the cliff. Thus we have the classic case of "greed vs. panic."

Having noticed this problem some 30 years ago, I spent the last three decades building an algorithm called Friedrich. Our algorithm was designed to assist all investors (both Pro and Novice alike) and give them the ability to quickly compare a company's Main Street operations, to its Wall Street valuation (Overbought or Oversold condition). Friedrich can do this on an individual company basis or assist users in analyzing an entire index like the S&P 500, an ETF, Mutual Fund or individual portfolio.

Many years ago, while reading Berkshire Hathaway's (NYSE:BRK.B) (NYSE:BRK.A) 1986 letter to shareholders, I discovered a ratio, which Mr. Buffett entitled "Owner Earnings," or what we may consider to be Mr. Buffett's version of "Free Cash Flow." To my amazement, in that little footnote, Mr. Buffett explains how to use it and basically states that it is one of the key ratios that he and Charlie Munger used in analyzing stocks. In that article, he defined the term "owner earnings" as the cash that is generated by the company's business operations.

[Owner earnings] represent (NYSE:A) reported earnings plus (NYSE:B) depreciation, depletion, amortization, and certain other non-cash charges…less (NYSE: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."

I have used this free cash flow ratio for decades, using data from the Value Line Investment Survey, whose founder was Arnold Bernhard. Mr. Bernhard was a big fan of free cash flow and probably introduced it sooner than Mr. Buffett did. I know this as I was able to calculate the FCF ratio using old Value Line's sheets for my 60-year backtest of the DJIA from 1950-2009.

In the backtest that I mentioned above, I demonstrated that if one can purchase a company whose shares are selling for 15 times or less its Price to Free Cash Flow Ratio, that the probability of success will dramatically increase in most cases. I have renamed the ratio the Bernhard Buffett Free Cash Flow ratio in honor of both men. The following is how that ratio below is calculated.

Price to Bernhard Buffett Free Cash Flow Ratio = Sherlock Debt Divisor/ [(net income per share + depreciation per share) + (capital spending per diluted share)]

Sherlock Debt Divisor = Market Price Per Share - ((Working Capital - Long-Term Debt)/Diluted Shares Outstanding))

The above are the ratios I use when analyzing a stock on Wall Street and below are the ratios I use when analyzing a stock on Main Street.

FROIC means "Free Cash Flow Return on Invested Capital"

Forward Free Cash Flow = [((Net Income + Depreciation) (1+ % Revenue Growth rate)) + (Capital Spending)]

FROIC = (Forward Free Cash Flow)/ (Long-Term Debt + Shareholders' Equity)

What the FROIC ratio does is tell us how much forward free cash flow the company is generating on Main Street relative to how much total capital it has employed. So, if a company invests $100 in total capital on Main Street and generates $20 in forward free cash flow, it therefore has a FROIC of 20%, which we consider excellent. This is just one of the key ratios (66 in total) that we use to identify how a company is performing on Main Street, as it is our belief that if a company is making a killing on Main Street, that this news will eventually show up on Wall Street's radar.

So, let us begin our analysis and at the same time try to teach everyone how to do a similar analysis on one's own portfolio. In analyzing Apple's Price to Bernhard Buffett FCF ratio we must first analyze Apple's Sherlock Debt Divisor. Here is a detailed definition of what that ratio is:

Sherlock Debt Divisor = A major concern that I have these days in analyzing companies is the amount of debt each takes on relative to its operations and whether management is abusing this situation by taking on more debt than it requires. Debt, when used wisely, allows for what is called leverage and leverage can be extremely beneficial within certain parameters. On the other side of the coin, the use of debt can also be excessive and put a company's future in jeopardy. So, what I have done to determine if a company's debt policy is beneficial or abusive, is to create the Sherlock Debt Divisor.

What the Divisor does is punish companies that use debt unwisely and rewards those who successfully use debt as leverage. How do I do this? Well, I take a company's working capital and subtract its long-term debt. If a company has a lot more working capital than long-term debt, I reward it and punish those whose long-term debt exceeds its working capital. So, if this result is higher than the current stock market price, then leverage is being used and the more leveraged a company is, the worse the results of this ratio will be and the less attractive its stock will be as an investment.

Thus, having successfully defined the Sherlock Debt Divisor, we need the following four bits of financial data in order to calculate it for Apple. TTM for those who don't know is "trailing 12 months" or as close to real time data as we can get, based on when each company reports.

Market Price Per Share = $133.62

Working Capital = Total Current Assets - Total Current Liabilities

Total Current Assets = $103,332,000,000

Total Current Liabilities = $84,130,000,000

Working Capital = $19,202,000,000

Long-Term Debt = $73,557,000,000

Diluted Shares Outstanding = 5,328,000,000

Sherlock Debt Divisor = Market Price Per Share - ((Working Capital - Long-Term Debt)/Diluted Shares Outstanding))

Sherlock Debt Divisor = $133.62 - (($19,202,000,000 - $73,557,000,000)/5,328,000,000))

Sherlock Debt Divisor = $133.62 - (-$10.20) = $143.82

Since Apple has more Long-Term Debt vs. Working Capital, we, therefore, must punish it and use the new $143.82 as our new numerator in all our calculations.

Price to Bernhard Buffett FCF Ratio = Sherlock Debt Divisor/ [(net income per share + depreciation per share) + (capital spending per diluted share)]

Sherlock Debt Divisor = $143.82

Net Income per diluted share = $45,217,000,000/5,328,000,000 = $8.49

Depreciation per diluted share = $10,538,000,000/5,328,000,000 = $1.98

Capital Spending per diluted share = $-12,456,000,000/5,328,000,000 = $-2.34

$8.49 + $1.98 + ($-2.34) = $8.13

Price to Bernhard Buffett Free Cash Flow Ratio = $143.82/$8.13 =17.70

Now if one goes to our FRIEDRICH LEGEND (on what is considered a good or bad result) you will notice that our result of 17.70 is considered good.

We last ran our Datafile for Apple on February 13, 2017, and our Friedrich Algorithm gave a recommendation to our subscribers that Apple is a "Strong Hold" as our Friedrich Datafile and Chart below show. There you will also find the last ten years of Apple's Price to Bernhard Buffett Free Cash Flow results.

Now that we have taught everyone how to calculate our Price to Bernhard Buffett Free Cash Flow ratio, let us now move on and teach everyone how to calculate our FROIC ratio.

This is how we calculate it:

FROIC means "Free Cash Flow Return on Invested Capital"

Forward Free Cash Flow = [((Net Income + Depreciation) (1+ % Revenue Growth rate)) + (Capital Spending)]

FROIC = (Forward Free Cash Flow)/ (Long-Term Debt + Shareholders' Equity)

Net Income per diluted share = $45,217,000,000/5,328,000,000 = $8.49

Depreciation per diluted share = $10,538,000,000/5,328,000,000 = $1.98

Capital Spending per diluted share = $-12,456,000,000/5,328,000,000 = $-2.34

Revenue Growth Rate TTM = 1%

[(($8.49 + $1.98) (1.01%)) + ($-2.34) =$8.23

Long-Term Debt = $73,557,000,000

Shareholders Equity = $132,390,000,000

Diluted Shares Outstanding = 5,328,000,000

FROIC = (Forward Free Cash Flow)/ (Long-Term Debt + Shareholders' Equity)

$8.23/$38.65 = 21%

FROIC = 21%

Now if one goes to my FRIEDRICH LEGEND again (on what is considered a good or bad result) you will notice that our result of 21% is an excellent result and tells us that Apple on Main Street generates $21 in forward free cash flow for every $100 it invests in total capital employed.

On Main Street Apple is doing great, while on Wall Street it is far from overbought. Now if one can build a portfolio containing similar excellent Main Street results and buy all at attractive Price to Bernhard Buffett Free Cash Flow ratio results, then your portfolio should be a star on both Main Street and Wall Street. Finding companies that have excellent results on Main Street and Wall Street (simultaneously) these days is unfortunately like trying to find a needle in a haystack. In order to prove this point I have analyzed the S&P 500 Index using the exact same methodology and produced final Main Street (FROIC) and Wall Street (Price to Bernhard Buffett FCF) results for the entire index.

The final results for the S&P 500 Index are:

FROIC = 12%

Price to Bernhard Buffett FCF = 38.34

For FROIC, we consider any result above 20% to be excellent and any result above 10% to be good, so the S&P 500 index in having a FROIC of 12%, can be considered good and tells us (that as a group on Main Street) the components of the index are doing well.

The problem is that Wall Street has "overbought" the index, giving it a score of 38.34 for our Price to Bernhard Buffett FCF ratio. That ratio considers a stock a bargain when it trades under 15 times and overbought when it trades over 30 times. Therefore, the S&P 500 index is some 8.34 points or about 28% in "overbought" territory.

When analyzing the table above we set up certain rules to use when analyzing any group of stocks, such as one's own portfolio:

1) if a stock has a negative FROIC result, we automatically assign it a score of 100 for its Price to Bernhard Buffett FCF ratio, in order to keep everything consistent and logical, as you can't have a negative Price to Bernhard Buffett FCF ratio when analyzing portfolios.

2) Then at the same time the maximum FROIC allowed is 100%, so we can keep everything consistent and logical as well, as anything higher distorts the results for the group.

3) We also give a zero result for FROIC for any "cash position" in the portfolio and a 22.50 result for the Price to Buffett Free Cash Flow, (which is 15 (buy) + 30 (sell) = 45/2 = 22.50). This was done to force one never to feel comfortable in cash, unless one has no choice in the matter, like we are now. Our real time research clearly shows that the markets are overvalued, as measured by our analysis of the S&P 500 index.

Going Forward, if you want to duplicate this same analysis for your own portfolio, it will require some effort on your part, in order to calculate the FROIC and Price to Bernhard Buffett ratio for each holding. But once you have done that, then you simply weigh each holding in your portfolio and then multiply that weighting result by each holding's FROIC result and then by each holding's Price to Bernhard Buffett result. Then sum each column's results and that will give you the final results for both ratios for your portfolio. Then you can act based on how your portfolio stacks up on Main Street vs. Wall Street and can also easily compare it to any index. For those who don't want to do the leg work on your own we offer a service where we have done the calculations for 4000 US stocks and soon to be 16,000 global stocks from 27 countries.

In conclusion, it is my belief that free cash flow analysis is the ultimate tool when analyzing companies, and my hope is that you may add these ratios to your own investor tool box in order to help you in your own due diligence. If you have any questions, please feel free to ask them in the comment section below and don't forget to hit the "Follow" button after our Friedrich Research username on top as now that we are able to analyze indices, we will then proceed to analyze ETFs, Mutual Funds and certain popular portfolio managers' (gurus) portfolios in a series of articles here on Seeking Alpha. Since most use the S&P 500 Index as the comparative benchmark, we can see how each is doing in a side-by-side comparison.

Disclosure: I am/we are long AAPL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: DISCLAIMER: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.