By Norm Klopp, CFA, Partner

In 1999 and earlier this year, as many stocks — especially those of high-tech or Internet companies — soared to unrealistic levels, some market-watchers said that corporate earnings, cash flow, return-on-assets, and other financial fundamentals were no longer important considerations in placing a value on common stock. We disagree.

At Midwest Investment Management, we believe the long-term value, or intrinsic value, of a common stock is significantly determined by a company’s ability to generate growing cash flow on a sustained basis. Further, we believe that the key to investment success is having a sound, disciplined means of analyzing and monitoring cash flow growth. That is our response to some market observers who say that fundamentals no longer count.

The findings in a 15-year study support our position. The best determination of future stock prices, says an analysis by the Chicago-based consulting firm, Holt Value Associates, is the ability of a company’s management to deliver high and growing cash returns.

What is cash flow?
Stated simply, cash flow consists of earnings plus non-cash charges, such as depreciation and amortization. It is this available cash each year that management uses to expand facilities, develop new products, pay dividends, buy back stock and make acquisitions. Cash generation is key to long-term growth and shareholder value.

Consistent analytical system
Cash Flow Return on Investment (CFROI) measures a company’s cash generating ability. This discipline was developed by Holt Value Associates, who provide us with sophisticated analytical tools used in our research process.

The value of the CFROI discipline is that it uses a consistent analytical system to measure the past annual levels of cash generation of a company. It also projects future cash generation based upon consensus earnings estimates. The discipline then adjusts the assets of the company to their current value and calculates a level of cash return that the company is earning on the inflation-adjusted value of those assets.

Current Value Important
To reduce this idea to a simple example, if a company had $100 worth of assets and was generating $10 in cash flow annually, its CFROI would be 10%. The importance of using a current value for the assets is evident in the fact that if the asset was 10 years old and had been depreciated on the company’s balance sheet to a $50 value, the cash return would increase to 20% ($10/$50 = $20%). That, however, would not be a true reflection of the return that would be generated if the management bought the asset at today’s cost.

The final piece of this analysis asks the question: Is this cash return (CFROI) higher than the company’s cost of capital? Cost of capital is a combination of the interest rate a company pays on its debt and the price/earnings ratio of its common stock. Think about this scenario: If it “costs” a company 7% for capital and it’s earning only a 5% cash return on that capital, it is “losing” money on each investment it is making. Said another way, the company is not “creating value” for the shareholders. Management has no financial right to invest the shareholders’ money in the business.

Combination of factors
This combination of CFROI factors answer the question: Is the management of this company able to earn a cash return on its currently valued assets that exceeds its cost of capital, and is it able to increase that return consistently or maintain it at a high level? If the answer is “yes” and management can grow its business (assets), it is consistently increasing shareholder value. Analysis has shown that this will be reflected in superior stock market performance.
Our basis for that statement is in the table below that shows the results of a 15-year correlation analysis of various fundamental factors to stock price performance.

Drivers of Shareholder Value
1
1	1	Impact on Stock Price Factor*
Earnings Growth	1	0
Return on Capital	1	31%
Return on Equity	1	44%
CFROI	1	70%
1
*Defined as R2 in correlation analysis

The ability of management to deliver high and growing cash returns (CFROI) is by far the best determinant of future stock price.

Our challenge is to use this discipline to identify those superior company managements that can create value, and to use our research process to analyze and monitor their ability to continue to improve their returns. This is the focus of our analytical effort using this proven discipline.

If you have questions or comments, you may contact Norm Klopp at
(216) 830-1135 or e-mail: nfk@mimllc.com.

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Perspective is published quarterly by Midwest Investment Management LLC, Cleveland, Ohio for its clients, friends and members of the business community. All information contained herein reflects the opinions of the authors and does not necessarily constitute investment advice. Past results are no guarantee of future performance. ©2000, Midwest Investment Management LLC. All rights reserved.