Category: Financial Analysis

Net asset valuation, funds from operations, and intangibles

Published on:
January 17, 2020
Read time: 9 Minutes
Last Update:

***This is a free chapter from my guide on how to value REIT stocks. Subscribe to access the rest of the guide, and so much more.***

The Income approach

Funds From Operations

Funds from operations are the REIT's net earnings without non-cash or non-operating expenses. To the net income, we add (1) depreciation and amortization, (2) gains and losses from real estate sales, and (4) any impairment write-downs of real estate.

Because GAAP accounting requires an annual depreciation of real estate [1], the intent behind FFO is to get us closer to the economic truth. Yet funds from operations exclude capital expenditures. And omitting this expense results in an optimistic measure of earnings.

Adjusted funds from operations

So the real estate industry includes a second earnings measure called adjusted funds from operations (AFFO). It is often reported by management in the annual report.

In AFFO reporting, management discusses the amount of cash spent on the maintenance of existing properties and the development of new properties and acquisitions.

To calculate the adjusted funds from operations, we use the funds from operations minus capital expenditures. We then adjust for straight-lining of rents and any one-time loss or gain. We then add back amortization related to stock compensation and other deferred costs.


AFFO is a superior measure to the FFO because the maintenance of real estate, whether it is renovating the lobby or replacing the roof, is a real and frequent cost that affects cash flow. To see the difference between net earnings, funds from operations, and adjusted funds from operations, I will use Plymouth Industrial Reit as an example.

For 2017, Plymouth reported a net loss of $14 million. But if we add back depreciation of $14 million and remove the gain of $231 thousand from real estate sale, we arrive at FFO of $260 thousand. To arrive at AFFO, we further deduct for the recurring capital expenditures, straight-line rents, and add back non-cash interest expense, acquisition costs, and stock compensation. We get an AFFO of $818 thousand.

So we found three numbers that tell a different story. Returning to Plymouth, the 5-year average net loss was $25 million. The 5-year average loss from funds from operations was $17 million, and the 5-year average loss from adjusted funds from operations was $9 million. In 2017, all three numbers improved, and the company showed a profit in AFFO.

Similar to the price to earnings ratio, REIT investors estimate whether a REIT stock price is a bargain or expensive using multiplies such as price to FFO ratio or price to AFFO ratio. And observing these ratios over time provides a signal of how the stock market values the company. It also allows us to see the relative value across companies. Judging by the price to FFO ratio, the stock market believes that Essex Property Trust is superior to Mid-America Apartment Communities.

For Essex, between 2013 and 2017, funds from operations were as low as $7.6 (in 2013) and as high as $11.191 (in 2017). And during this time, the average price to FFO ranged between 20 and 23 times.

For Mid-America, FFO was as low as $4.34 and as high as $6.15. The 5-year average price to FFO was 15 times. For over five years, the stock market felt Essex was worth 33% more than Mid-America.

What are some of the reasons that a REIT stock is priced higher?

Let's look at three reasons. The first is growth expectation. If REIT's A portfolio of real estate is earning below-market rents, future earnings will likely to grow. Another reason for a growth premium is that the portfolio of real estate is in areas in high demand — for example, apartment buildings in San Francisco or Vancouver.

The second reason is associated with risk. Say REIT's A portfolio of real estate consists of apartments. And let's assume REIT B owns single, anchor-tenant shopping malls. Then investors will demand a discount for the additional risk [2] they take by holding REIT B.

The third reason is the capital structure. If REIT A carries more debt than REIT B, then investors will view REIT A to be riskier and will demand a discount to the net asset value.

If REIT A has preferred stockholders who are paid a dividend before the common stockholders, then investors demand a discount too.

Funds from operations do not include the value of land, for example. So, if a REIT has a substantial number of projects under development, which currently are not generating any income, then the price to funds from operations may appear artificially high.

Adjusted funds from operations are supposed to bring us closer to the real earnings of a REIT. But capital expenditure varies each year. It is impossible to compare a single year's AFFO. And since many REIT companies do not report AFFO measures - and since there is no standard calculation of the metric - for now at least, AFFO remains a subjective number.

The asset approach (net asset valuation)

The math behind the net asset value calculation is straightforward. We look for the net operating income, as reported on the REIT's public filings. And based on the capitalization rate for similar assets, we then determine the value of the real estate by dividing the net operating income by the capitalization rate.

To that number, we add any cash the REIT holds and any other assets that represent an actual economic value, such as account receivables. We then remove the total liabilities as well as the value of the preferred stocks. The result is the REIT's net asset value.

An illustration: Equity Office Properties Trust (EOP on Nasdaq), reported a net operating income of $271 million last year. Based on recent comparable transactions, we can estimate a capitalization rate of 7.0% and thus determine a value of $3.8 billion for the portfolio of real estate.

We then add the reported cash balance of $65 million, the land of $34 million, the accounts receivable of $46 million, and other prepaid assets of $23 million. We get $4.04 billion in estimated market value. The reported total liabilities were $1.2 billion, and so our net asset value is $2.9 billion or $52 per share [3]  

Let us return to Equity Office to examine that statement. During 2018 the common stock of EOP traded hands as low as $44 and as high as $56. In other words, during this time, the stock's discount was 15%, and the stock's premium was 7%.

The discount or premium to book value also allows us to compare among REIT companies and across industries. We see the stock market finds the ownership of retail riskier than the ownership of industrial properties. For example, Rexford Industrial is trading at an implied capitalization rate of 3.4% while Weingarten Realty Investors (WRI on Nyse) is trading at 6.3% implied capitalization rate.

(We can see retail's gradual devaluation over the past few years because of Amazon.)

Four years ago, Retail Properties of America (RPAI on Nyse) traded at an implied capitalization rate of 6.6% while today it is trading at an implied capitalization rate of 7.7%. Similarly, Weingarten Realty Investors (WRI) traded in 2013 at a capitalization rate of 5.4%, while today it is trading at a capitalization rate of 6.3%.

How to calculate an implied capitalization rate

Consider Rexford Industrial Realty. Instead of estimating a capitalization rate to find the value of the real estate, let us name the market value of the real estate at X. To that we will add $6.6 million cash, $19.5 million of receivables and deduct total liabilities of $746 million and the $90 of preferred stock.

We find a value of $3.5 billion for the real estate portfolio. And since the company reported an NOI of $118.2 million, the implied capitalization rate is 3.4%. The estimated implied capitalization rate is between 3% and 10%, which is a minuscule rate of return. An implied capitalization rate of 15% or higher should pick our interest.

Because we determine the market value of the real estate by dividing the net operating income by the capitalization rate, we fail to see whether the rental rate is below- above- or at the market.

Seritage Growth Properties (SRG on Nyse) serves as an another example. As of its most recent public filing, the company average annual rental revenue was, I estimate, about a quarter of the market rents. This is because 54% of the rental is from Sears Holdings, which has a master lease.

The second issue was the non-linear sensitivity of the estimated value of the real estate portfolio to changes in the assumed capitalization rate. If the capitalization rate changes from 5% to 4%, a 20% difference, for a real estate portfolio that is generating $100 million in NOI, the value would increase from $2 billion to $2.5 billion, a 25% difference.

Inversely, the difference between a 5% capitalization rate and a 6% capitalization rate changes the value of the portfolio from $2 billion to $1.67 billion, a 16% difference. In short, the value of the real estate assets was highly sensitive to the capitalization rate estimate.

The qualitative (intangible value) approach

To properly value REIT stocks, calculating numbers is not enough. There are intangible variables, such as management experience and corporate culture, which are at least as necessary as the variables that we can count.

In searching for excellent management, we focus on four things. The first is to look at management's track record in real estate ownership and in communicating on the state of the business with shareholders.

The second is to find out how much ownership stake management has. If you look at Simon Properties Group (SPG) on Yahoo Finance, for example, you will quickly learn that management owns less than 1% of outstanding shares.

The third is about incentives. Here we ask is management's interest aligned with the wellbeing of the investor?

Returning to the example of Simon Properties, over the past two years, executives of the company have sold 8,189 shares and did not purchase a single stock. A possible interpretation is that if management is not buying its shares, then management expects the stock price to drop.

To estimate future rental income and potential growth, we should look at the operations of each property in the REIT's portfolio. The most popular indicators of value are the location of the property, the occupancy rates, and whether the in-place rents are higher or lower than market rents.

Consider the retail REIT Saul Centers (BFS on Nyse). BFS owns 49 neighborhood shopping centers and six mixed-use properties, and no single property was more than 10% of the total portfolio of 9.2 million in square feet. But about two-thirds of the shopping centers were anchored by a grocery store.

What this data point means is that while the portfolio of real estate is well diversified, it is sensitive to how we will shop in the future; i.e., the more consumers use Amazon Prime, the harder it will be for Saul Centers in the future. This information is not reflected in the reported FFO or estimated NAV.

The right side of the balance sheet

Whether a REIT carries variable or fixed debt will affect its future financials also. This information is readily available in the footnotes section of the annual report filed with the Securities and Exchange Commission.

With a dormant interest rate environment, as the one we saw between 2008 and 2017, whether the REIT financed its operations using fixed or variable debt was not as important as it is today.

But today, the 5-year Treasury, an index often used to price commercial real estate loans, has increased from 2.25% to 2.85%, about a third increase in the cost of debt.

The rising interest rate environment affects all companies. But companies that carry variable debt will be hurt. Saul Center's debt is fixed at a weighted average of 5.25%. Compare that to CBL & Associates (CBL on Nyse), which is paying a lower weighted average of 4.75% - but that is because a third of its outstanding debt is variable.

In The Corporate Governance of Listed Companies: A Manual for Investors, the CFA Institute writes that board members should be independent from management. Board members should have appropriate experience and expertise. And internal mechanisms, such as an authority to hire external auditors, are required.

Simon Property Group has outstanding corporate governance. Each member of the Board's audit, compensation, and governance and nominating committees is independent. This is an example of a qualitative variable that is absent from the financial statements.


While there are additional qualitative variables, such as franchise value and what I call the "capital expenditure biography," which aims to understand how well management has acquired and managed real estate, I would like to end this chapter on valuation with Seth Klarman's 80/20 rule. In his words:

"Some investors insist on trying to obtain perfect knowledge about their impending investments, researching companies until they think they know everything there is to know about them. They study the industry and the competition, contact former employees, industry consultants and analysts, and become personally acquainted with top management. They analyze financial statements for the past decade and stock price trends for even longer."

He then continues:

"This diligence is admirable, but it has two shortcomings. First, no matter how much research is performed, some information always remains elusive; investors must learn to live with less than complete information. Second, even if an investor could know all the facts about an investment, he or she would not necessarily profit...Information generally follows the well-known 80/20 rule: the first 80 percent of the available information is gathered in the first 20 percent of the time spent."

If I leave you with one thing, it is to remember that to understand a business requires both math-skills and thought-skills. The math-skills require us to look for net asset value and to determine what are the funds from operations. The thought-skills require us to observe the business and the industry.

FOOTNOTES: [1] In reality, real estate often appreciates in value. [2] If one tenant leaves, the shopping center is vacant. [3] There were 55.6 million outstanding shares.

EV to EBITDA Ratio

Published on:
November 30, 2019
Reading Time: 3 Minutes.
Last Update:

Enterprise value (ev) is the market value of the debt and equity less cash held by the company. Earnings before interest, taxes, depreciation, and amortization (ebitda) is a proxy for how much cash flow does the business generates. By dividing the enterprise value by ebitda numbers, you discover how long will it take for the company to pay back the initial investment.

The shorter the period the better it is. For example, a business that generates $33,000 a year is more attractive than a business that makes $14,000, assuming both will last and cost the same.

The ev to ebitda ratio represents this idea. "What a ratio of eight times ev to ebitda," writes Michael Shearn in The Investment Checklist, "is that the investment will pay itself in eight years."

Read how to calculate ev to ebitda ratio on Investopedia or visit for ways to compare ev to ebitda ratios among companies.

In this essay, I describe the ratio's main weaknesses and how you can better prepare for them. I end the article with a few examples of companies trading at low ev to ebitda ratios. 

The flaws of ev to ebitda 

There is a reason why Charlie Munger called ebitda earnings "bullshit earnings." In his mind, ebitda misses out on two key points: the amount of leverage and the amount of capital expenditures required to maintain the business.

If ebitda portrays a distorted reality, then the ratio that uses ebitda in its denominator must obstruct reality, too.

Another flaw of the ratio is that it looks at a single point in time. But what matters to investors are trends over time. That is, whether earnings will grow in the future is more important than current earnings or last year's earnings. 

For example, in June of this year, I bought the stock of Signet Jewelries (SIG on Nyse) One of the reasons I purchased SIG was because for the prior seven years, the average  was $800 million. But because the 2018  was loss $579 million, the stock had more than halved.  to  cannot pick up such a discrepancy. 

Like most things in life, the problem does not lie in the ev to ebitda ratio but how the user intends to use it. I typically use ev to ebitda ratio to quickly screen for cheap stocks[1]. Other investors use the inverse logic; they use the ratio to estimate how valuable a company is. They assume that the higher the ratio, the more valuable the company. 

The uses of ev to ebitda 

Yet, even with the flaws mentioned, ev to ebitda ratio is widely used, and ebitda figures are widely accepted. Read any loan covenants of a publicly-traded firm and you will see that lender covenants that address  ebitda figures. That is, if ebitda for a quarter falls below a specific number, a higher interest rate will be charged. 

And so, to use Silicon Valley nomenclature, this ratio exhibits a "network effect." One of its strengths is that it is widely used by both companies and by Wall Street analysts.

One of the strengths behind the ev to ebitda ratio is its popularity by both lenders and analysts.

Take, Luca Franza of Ausonio Fund as example.In the now famed investment thesis for Rain Industries, he writes: 

"Rain trades at a P/E of 2.7x and EV/EBITDA multiple of 5.1x. Using cyclically adjusted earnings and EBITDA, which we will assume to be the average over the last five years, Rain trades at a P/E of 1.7x and EV/EBITDA of 4.2x."  

Another use of the ev to ebitda ratio is that it allows us to observe a company's valuation over time. Canterbury Consulting shows, in a quarterly asset class report, that for the Russell 2000, a popular index, /  was 16 times, while the 10-year average ratio was 14 times, and. For the S&P500, Canterbury researchers show that the current TDA was 1mes, while the 10-year average was ten times. You can download the Canturbury report.

When bored, I enjoy finding out the ev to ebitda ratio of portfolio companies owned by asset managers I admire. For example, a few weeks ago, I reviewed Third Street Avenue Capital Management. I saw that for the 31 companies Third Street owned as of the second quarter of this year, most portfolio companies ev to ebitda was in the double digits. Only Carter Bank Trust Advansix Inc. traded at a ratio of six times; MYR Group at a ratio of seven times. The other single-digit companies, at nine times the ev to ebitda, were Seaboard Corporation, Comfort Systems and TRI Pointe Group and Kaiser Aluminum Corporation.


Founded in 2004, by Charlie Tian PHD, GuruFocus provides institutional-quality financial stock research for the individual investor.

GuruFocus hosts many value screeners and research tools and regularly publishes articles about value investing strategies and ideas. One of the features I use most is the 30-year financial information on businesses. For example, see how easy it is to review Signet Jewelers 10-year financials.


Examples of companies trading at a low ev/ebitda

I often screen for stocks trading at low ev/ebitda. While it is insufficient to make an investment decision based on the ratio, it does serve as a starting point or as a filter mechanism. I conclude this essay with three companies in my portfolio that are trading below three times the ev to ebitda ratio.

EV to EBITDA in my stock portfolio
Some low EV/EBITDA ratio companies in my portfolio

First, the sport-equipment manufacturer Nautilus' enterprise value is $54 million, and ebitda is $31 million. Second, Flexsteel Industries, the sofa manufacture, enterprise value is $102 million, and 2018 ebitda is $33 million. Third, Gulfport Energy, a producer of natural gas, enterprise value is $2,670 million, and 2018 ebitda is $1,046 million.

[1 ] A ratio of EV to EBITDA less than 3 times is considered a bargain valuation.

I drink your milkshake!

Published on:
August 31, 2019
Last Update:

The gas and oil industry is not for the faint of heart. The S&P Oil and Gas Equipment services halved this year and is down 80% compared to five years ago. And from the macro to the micro: Noble Corporation (NE on Nyse), whose price is now less than two dollars a share, traded for $28 per share in five years ago. Gulfport Energy (GPOR on Nasdaq), which I bought a few months ago, now trades at $3 compared to $60 five years ago. At least the two firms are still in business. Atwood Oceanics, Inc., Hercules Offshore, Inc. and Paragon Offshore PLC - all filed for bankruptcy protection.

It is a cyclical business per se. In The Investment Checklist , Michael Shearn writes that "certain industries operate independently of the economic cycle. In such case, the product or service may be more of a necessity." He lists tobacco companies, pipelines carrying oil and gas and student housing REITs as examples. And as the U.S. economy continues to expand (the longest expansion recorded), the oil and gas industry contracts. What goes down must go up?      

To answer, we should first look at the demand variables. I refer the reader to page 12 of the NE's 10-K report for example, where management discusses 25 factors that affect the price of oil and gas and the level of activity in offshore exploration.

To name just a few of the factors: the level of production in non-OPEC countries, merger and divestiture activity among oil and gas products, the political environment of oil-producing regions (including uncertainty or instability resulting from civil disorder) and the discovery rate of new oil and gas reserves either onshore or offshore.

In short, to foresee where the oil and gas industries are heading is to prognosticate.

The gas and oil industry is depressed because the price of crude oil is down and because oil supply exceeds demand. Is it temporary? 

So instead let us name a few of the current reasons why the industry and its shareholders are depressed. First is the price of oil. Five years ago a barrel of WTI Crude Oil[1] cost over $90. It is now about $55. And not unlike the gold rush, if commodity price is down, no one tries to dig it out of the ground.

WTI average price since 1969
WTI's 10-year average price since 1969

The second reason is that daily crude oil production increased to four million from one and half million barrels. So, the demand of service from offshore fields, which are more expensive, declined.

The third reason is the demand and supply equation. There are simply too many rig suppliers and too little demand for them.

Yet I think the imbalance is temporary. Visit the Macrotrend website to see that over the past decade, the price of oil moved - and at times, frantically up and down - but upwards was the overall trend. Or instead of staring at the computer screen, you can just ask anyone older than sixty-five if gas prices were cheaper or more expensive when they were thirty.

Noble Energy  

So I speculate that the price of oil will rise again and that the price of gas and oil companies will eventually follow. I made this bet by buying a few shares in Noble Energy.

While Noble is now fraught with many risks (to name a few: the company is being sued; it is burning cash flow and the leverage ratio[2] and interest expense ratio are higher than ever before), I focused most of the reading about the company before the gas and oil industry turned sour.

Noble's management is shareholder-friendly with a successful track record. But major risks lie ahead.

And when times were good, Noble operated with a shareholder-oriented management as it never made acquisitions using equity but instead used debt and internal cash flow; It ran a conservative balance sheet with a leverage ratio of less than 40%.

More numbers: Five years ago Noble was valued over one times the company's 2014 revenue. It now trades at less than half the 2018 revenue. It is also trading at historically significant discount to book value. At the end of 2014 the book value per share was $26, and during that year the stock traded hands as high as $33 and as low as $14. The minimum price to book value was 54%. Contrast that with today's pricing. Today, the company reports a book value of $18 per share and a two-dollar price tag is 89% discount to book value.

NE's price to book value per share over past decade
NE's price to book value per share over past decade


Before I bought the stock of Gulport and Noble, I knew little about the gas and oil industry. The following two books tremendously helped: Written by Jens Zimmermann, The Oil and Gas Industry Guide: Key Insights for Investment Professionals  contains key valuation methods and industry knowledge. It is a somewhat technical book.

For broader understanding of the business, Bryan Burrough’s The Big Rich: The Rise and Fall of the Greatest Texas Oil Fortunes is a colorful portrayal of the industry's eccentric characters.

[1] West Texas Intermediate (WTI) crude oil is the most popular oil benchmark.  
[2] For example, the 2014 leverage ratio was 45%; it is now 51%. The adjusted interest coverage ratio was over ten times in 2014; it is now one times.  

Is Treasury Stock an Asset?

Published on:
June 8, 2019
Last Update:

You can teach math to a horse but the horse will never be a mathematician. Similarly accountants teach us, readers of financial statements, that treasury stock is equity. But I argue that treasury stock is an asset.

Generally Accepted Accounting Principles (GAAP) says that "assets are probable future economic benefits obtained or controlled by a specific company as result of past transactions or events."

An asset has three characteristics: (1) it is likely to contribute directly or indirectly to future net cash flows, (2) the company can obtain and control others' access to it and (3) the transaction has already occurred.

When a company buys its own stock management is signaling to investors that the stock is undervalued. Also, when a company buys back its shares, each investor's ownership interest increases. So stock buybacks are valuable and meet the three characteristics of an asset.  


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Two examples of the distorted reality behind treasury stock

Yet the accounting is goofy. Consider International Business Machines (IBM on Nyse). Over the past decade, IBM's balance sheet showed deficits in the equity balance. In 2018 the loss in equity balance was $25 per share. And yet during this 10-year period, IBM was profitable (the 10-year average earnings per share is over $5). That a negative equity balance can produce profits is an accounting distortion.

The accounting distortion is the result of IBM's share repurchase program. In 2009 IBM had 1.3 billion outstanding common shares while management reported on 892 million outstanding shares as of the latest public filing, a compound annual decline of about 4% per year.

the effect of treasury stock on the balance sheet
The effect of IBM's buyback program

Another example is Signet Jewelers (SIG on Nyse) which I bought a few weeks ago. In 2019 SIG's management deducted from the equity balance $1,027 million because it bought 18.1 million shares. But just as the company bought the stock, management can sell the stock to the public. In SIG's case, using today's stock market, I estimated that management can easily sell the common stock at $15 per share (a 25% discount to current price) for total proceeds of $271 million or $5 per share.


Founded in 2004, by Charlie Tian PHD, GuruFocus provides institutional-quality financial stock research for the individual investor.

GuruFocus hosts many value screeners and research tools and regularly publishes articles about value investing strategies and ideas. One of the features I use most is the 30-year financial information on businesses. See how easy it is to track AT&T treasury stock purchases for example.


What GAAP says about treasury stock

I asked a friend of mine who is an accountant why treasury stock is part of the equity balance and not reported as part of the assets. She explained that if treasury stock would have been reported as an asset, the accounting would get goofier. For one, she explained, a potential buyer of a company would not consider treasury stock valuable. The buyer would remove treasury stock to arrive at a fair value. So from the buyer's perspective the classification change would not be helpful.

Another reason why reporting treasury stock as an asset does not work in practice is related to the price of the stock. If company ABC’s management buys the stock at $10, and a year after the price of the stock drops to $5, under GAAP rules, company ABC would report an impairment loss, directly affecting the income statement.

This would be a double-edged sword. Just as the company operations would deteriorate (the probable reason why the stock fell in price) the company would take a further loss to the income statement.

Does it even matter?

Students of financial history will remember that prior to 1982, stock repurchases were illegal. Buyback activity, which is expected to be greater than $800 billion in 2019, was considered a stock market manipulation according to Forbes.

This activity continues to be unfavored by some. For example Senators Chuck Schumer and Bernie Sanders proposed to limit corporate stock buybacks in a New York Times Op-Ed. Their main arguments were that stock buybacks hurt the economy because indirectly they discourage investment and innovation.

Trends in stock buybacks
The trend in stock buybacks. Data taken from the


Like many things in life, an action, in itself, is neither good nor bad. It just depends. It is bad action when management buys back the stock when the shares are overvalued (say, trading at above 30 times the trailing earnings per share).

It is good action when the inverse happens - when management buys back the stock at undervalued prices or if buying back the stock is the best available option.

Binary thinking just does not work in investing. Treasury stock is, at times, an asset; sometimes it’s part of the equity balance; and sometimes it's both. This similar to the Jewish tale:

Two neighbors were fighting over a financial dispute. They couldn’t reach an agreement, so they took their case to the local rabbi. The rabbi heard the first litigant’s case, nodded his head and said, “You’re right.”
The second litigant then stated his case. The rabbi heard him out, nodded again and said, “You’re also right.”
The rabbi’s attendant, who had been standing by this whole time, was justifiably confused. “But, Rebbe,” he asked, “how can they both be right?”
The rav thought about this for a moment before responding, “You’re right, too!”

On the stubbornness of facts

Published on:
March 31, 2019
Last Update:

"Facts are stubborn things," said my favorite American founder, John Adams. "And whatever may be our wishes, our inclinations or the dictates of our passions, they cannot alter the state of facts and evidence." And so, I collected a few facts about Frontier Communication for this week's meditation.

 A few facts on Frontier are needed because Frontier’s stock is trading at 71% compared to a year ago. And as most analysts are rushing investors to cut their losses and sell Frontier position, I plan to do the opposite.  

The 2018 earnings estimate

After adjusting for non-cash expenses, I expect Frontier to report on a billion dollars of after-tax cash flow. The company’s average quarterly revenue was $2.1 billion in 2018, the average quarterly expense for interest was $400 million and the average capital expenditures were $320 million. 

If we remove non-cash charges, such as depreciation ($480 million each quarter) and goodwill expense ($400 million in the third quarter), we get a quarterly after-tax cash flow of $250 million. Multiplied by four quarters, we get the billion-dollar estimate.  It is a fact that these after-tax earnings, adjusted for non-cash items, are higher than the after-tax earnings when the stock was trading in the double digits.  

Another way to look at my estimate of Frontier's 2018 after-tax cash flow of a billion dollars is to say that the company profit margin is about 12% and that while the debt service coverage ratio is thin, it is adequate. The operating income to debt service ratio is slightly above two times. It is a fact that operating income for 2018 will be higher than $3.9 billion and that the interest expense will be $1.5 billion.

As of the third quarter of 2018 public filing, Frontier reported total assets of $24 billion. If we remove goodwill of $6.6 billion, we find tangible assets of $17.4 billion. And so, with a rate of return of capital of 5.75%, I cannot understand why there is an increased demand in investors who are shorting the company. 

Twelve months ago, the short interest, as reported by Nasdaq, was $2.9 million with average daily volume of $2.7 million. As of today, the short interest is $49.4 million. The stock price declined from $8 to $2, too.    

The 5-year operating performance and the 10-year earnings multiple valuation

While operating results slightly improved, Frontier's valuation is materially below what the stock was valued in the past. Between 2013 and 2017, revenue grew by 14% compounded annually. In 2013, revenue was $4.7 billion, and in 2017 revenue was $9.1 billion. Earnings before taxes (EBT) grew by 6% compounded annually. The 2013 EBT was $1.5 billion, and the 2017 EBT was $2.02 billion. It is true that the after-tax cash flow declined from $857 million in 2013 to $618 million in 2017, but to me, a drop of 30% in after-tax cash flow does not explain the gloomy outlook.  

If we expand our time horizon and look at the past decade we see that the stock traded as high as $194 (in 2008) and as low as $2 (current valuation). The earning multiple ranged from 6 to 12 the earnings. My estimate of a billion in after tax cash flow, alongside the reported outstanding shares of $103 million, translates a market valuation of less than one times the earnings multiple.    

The market's view

But the stock market’s focus is in future trends (for example, that employess are unhappy) and not in the historical record. "Quarterly revenues continue to decline at Frontier Communication," writes Wayne Nef of Value Line, an investing newsletter. "Both the consumer segment and the commercial business are under pressure. Management is optimistic that the revenue trend will turn in the fourth quarter due to new marketing programs and seasonality, but we are less sanguine."

In Seeking Alpha, the crowd-sourced financial website, you will read of a bearish outlook, too. Here are a few headlines I found: "Frontier Communications: Fundamentals Are Meaningless in a Bear Market" writes one author. "After A 60% Decline, Frontier Communications Offers Little Value," argues another. And picked by Seeking Alpha's editor as a favorite article is "Frontier Communications is uinvestable."

Ashraf Essa, who writes for The Motley Fool, is bearish, too. He warns us that "Frontier's business is on the decline, and the company had about $1 billion worth of long-term debt coming due within the next year." And that Frontier Communications shaky business fundamentals, coupled with its massive debt load, make it an extremely risk stock to own."    

Securities lending

Since I began to buy the common stock of Frontier in March of last year, I did not pay much attention to the company. In 2017 the stock price was in the two digits and it would surely climb again, I thought to myself. I did not plan to think about Frontier before it published its 2018 fiscal year-end results, which was reported on February 28, 2019 and which I have yet to read.  

But Jeff, a Charles Schwab representative, called this morning and asked whether I would be interested in lending the securities I owned. There is an increasing short demand, he said. He offered an interest rate of 10%, which is the equivalent of two Starbucks per today.

The math behind the two-Starbucks-per-day: Charles Schwab is borrowing from me 8,000 stocks at a rate of 10%. The stock is today worth $18,000 (I bought the stock for little over $40,000). This translates to an annual payment of $1,800, or daily payment of $5. The terms of the agreement between us are that Schwab may pay off the loan at any time and payments are made every month.

In 1774, Adams renounced tea drinking as unpatriotic and switched to coffee drinking according to a letter he wrote to his wife, Amelia. He would have been supportive with my securities lending practice, I am quite sure.

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