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COUNTING ON CASH
David Dalgas
Kenneth Graversen
Klaus Ingemann
IN THIS PAPER: Cash is a powerful indicator for equity investors. Unlike accounting earnings, which are
often misleading, cash flows provide a clear picture of a companys underlying performance. When combined
with detailed fundamental research on a company and industry, cash can provide effective intelligence on
a companys future growth and stock price appreciation potential. In this paper, we present case studies to
show how an investment approach focused on cash flows can identify companies that generate strong and
sustainable equity returns.
For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public.
25
CFROI (Percent)
20
15
10
5
0
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014E 2015E
CFROI is a trademark or registered trademark of Credit Suisse Group AG or its affiliates in the US and other countries.
2
For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public.
Annualized Returns
19892014
High and
Stable CFROI
11.5%
High CFROI
11.1%
0.78
0.67
0.67
9.7%
Stable CFROI
MSCI ACWI
Return/Risk Ratio
19892014
5.9%
0.38
For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public.
COUNTING ON CASH 3
CFROI (Percent)
90
60
Barriers to entry
very high
30
0
04 05 06 07 08 09 10
11
12
13 14E 15E
Competition
not
price based
Direct financing
taking share
from banks/
intermediators
For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public.
Yet CFROI couldnt tell us what Sankyo was doing with all that cash.
If a company with a lot of cash doesnt invest in expansion, increase
its dividends or buy back shares, then it isnt creating much value for
its investors. In this case, after further investigation, we concluded
that Sankyos conservative management was unlikely to change; it
seemed to prefer to keep its cash locked up in its coffers rather than
put it to use on behalf of its shareholders.
Some companies have the opposite problemtoo little cash
and too much investment. When a company pumps money into
ambitious projects that arent likely to deliver reasonable rates
of return on capital, theyre destroying shareholder value. CFROI
can help investors avoid the stocks of companies that appear to
be on an unsustainable spending spree, like Sainsburys, the UK
supermarketchain.
Sainsburys has low returns and a growing asset basenot an
attractive combination. In 2014, the companys CFROI was less than
3%. Yet Sainsburys invested 888 million in its retail operations in
the fiscal year ending March 2014including 418 million to develop
new storesdestroying shareholder value in the process. In our view,
the companys aggressive focus on top-line revenue growthdespite
relatively low profitabilityraised the acute risk of subpar investment
returns in the coming years. CFROI helped us decide to steer clear.
Contrast these stories with Check Point Software Technologies. The
Israel-based company is a world leader in Internet security software,
and its CFROI was around 20% in late 2014. In fact, the company
was hoarding its cash, and its CFROI would have been significantly
higher if it had paid out all the excess cash from its balance sheet.
Its solid cash flows pointed to a defensible business model. On
further analysis, we found that Check Points leading position in the
Internet security industry is protected by a wide moat for several
reasons: It offers a broad range of products in an industry characterized by a sticky customer base. Its high pricing is supported by
For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public.
COUNTING ON CASH 5
80
Check Point
60
US Software Companies (Average)
40
95
97
99
01
03
05
07
09
11
13
VALUATION MATTERS
Valuation is also vital. Purchasing a company with strong potential
future cash flows and asset growth at an unattractive price is unlikely
For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public.
Consumer Staples
Information Technology
Healthcare
Industrials
Consumer Discretionary
Financials
Materials
Telecom
Energy
Utilities
4.4
14.5
11.9
11.5
10.9
8.6
8.1
7.3
19.5
18.7
Average
Analysis
Thesis
+ CFROI
+ Industry
Dynamics
+ Key Value
Drivers
+ Capital
Discipline
+ Financial
Model
Insight
and
Judgment
+ Intrinsic
Model
+ Worst-Case
Scenario
+ Minimum
20% Upside
Source: AB
For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public.
COUNTING ON CASH 7
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The HOLT methodology does not assign ratings or a target price to a security. It is an analytical tool that involves use of a set of proprietary quantitative algorithms and warranted
value calculations, collectively called the HOLT valuation model, that are consistently applied to all the companies included in its database. Third-party data (including consensus
earnings estimates) are systematically translated into a number of default variables and incorporated into the algorithms available in the HOLT valuation model. The source
financial statement, pricing, and earnings data provided by outside data vendors are subject to quality control and may also be adjusted to more closely measure the underlying
economics of firm performance. These adjustments provide consistency when analyzing a single company across time, or analyzing multiple companies across industries or
national borders. The default scenario that is produced by the HOLT valuation model establishes a warranted price for a security, and as the third-party data are updated, the
warranted price may also change. The default variables may also be adjusted to produce alternative warranted prices, any of which could occur. Additional information about the
HOLT methodology is available on request.
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