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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.


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 VisualCapitalist.com

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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!”

FFO is the one number all REIT investors look for

Published on:
December 14, 2018
Last Update:

Because GAAP accounting requires an annual depreciation of real estate, while in reality real estate often appreciates in value, the intent behind FFO is to get us closer to the economic truth.

The funds from operations definition

Funds from operations are the net income 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, (3) gains or losses from change in control and (4) impairment write-downs of real estate.

Yet funds from operations do not include capital expenditures. Omitting this expense results in an inflated, optimistic measure of earnings. So the real estate industry often includes a second measure called adjusted funds from operations (AFFO). Visit Investopedia.com for example how to calculate funds from operations.

Finding out what are the funds from operations will get us closer to the economic truth.

It is now often reported by management. In AFFO reporting, managements discusses the amount of cash spent on the maintenance of existing properties and on the development of new properties and acquisitions.

The adjusted funds from operations definition

To calculate the adjusted funds from operations, we use the funds from operations less capital expenditures and less any gains on sale. We then adjust for straight-lining of rent 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 wide difference between net earnings, funds from operations and adjusted funds from operations, I will use Plymount Industrial Reit most recent annual report.

For 2017 the company 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 get funds from operations of $260 thousand. To arrive at AFFO, we further deduct for the recurring capital expenditures, straight line rents and added back non-cash interest expense, acquisition costs and stock compensation. This results in AFFO of $818 thousand.

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So we arrived at three numbers that tell a different story. Returning to PLYM, 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 profit in AFFO. And it is the REIT investor’s job to determine whether the reported earnings are a sign of a better, promising future.

FFO of all listed U.S. equity REITs. Source: S&P Global Market Intelligence
FFO of all listed U.S. equity REITs. Source: S&P Global Market Intelligence

FFO and AFFO multiple

Like the popular price to earnings ratio, investors in REIT companies often estimate whether a stock is a bargain or expensive using multiplies such as price to FFO ratio or price to AFFO ratio. Observing these ratios over time provides a signal of how the stock market is valuing the company. And 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 a 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.

Observing the price to funds from operations ratio over time signals the changes in how the market values the real estate company.

For Mid-America the price to 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 ESS was worth 33% more than MAA. Let us move from the particular case of Essex versus Mid-America to the general cas and ask what are some of the reasons that one REIT stock is priced higher than a different REIT stock.

There are three common reasons. The first reason is growth expectation. If REIT’s A portfolio of real estate is currently earning below-market rents, a case could be made that future earnings will grow. Another reason for a growth premium is that the portfolio of real estate is in areas in high demand. Consider apartment rents in San Francisco or Vancouver.

The second reason is risk associated with the real estate. If REIT's A portfolio of real estate consists of apartments, while REIT's B portfolio of real estate consists of single, anchor-tenant shopping malls, then investors demand a discount for the additional risk they take (the risk is that if one tenant leaves, the shopping center is effectively shut down.)  

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The third reason is risk associated with capital structure. If REIT A carries more debt than REIT B than investors will view REIT A to be riskier and will demand a discount to the net asset value. If REIT A has preferred stock holders who are paid a dividend prior to the common stock holders, then investors would demand a discount, too.    

The aggregate price to FFO multiple for equity REITs compared to p/e multiple on the S&P 500. Source: S&P Global Market Intelligence
The aggregate price to FFO multiple for equity REITs compared to p/e multiple on the S&P 500. Source: S&P Global Market Intelligence

Funds from operations weakness

Fund from operations are not a perfect earnings measure. They 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 but are expected to generate income in the future, then the price to funds from operations ratio is artificially rich. Visit my analysis of Seritage Growth Properties to see an example.

Adjusted funds from operations bring us closer to the true earnings of a REIT. But since for most real estate projects, the capital expenditure varies significantly each year, it is practically impossible to compare between a single year's AFFO of Reit A to AFFO of Reit B.

And since many REIT companies do not report AFFO numbers- and since there is no standard calculation of the metric - for now at least, AFFO remains a subjective number.

The case of L Brands, Inc.

Published on:
September 30, 2018
Last Update:
September 3, 2019

You know something is strange when a profitable business reports a deficit in equity. Take L Brands, Inc. (LB on the big board), the American fashion retailer. Between 2008 and 2017 the company profited a total of $9.3 billion. Its yearly profits ranged from as low as $220 million (in 2008) to as high as $1.2 billion (in 2015).

Yet if you carefully look at the net equity balance during this decade-long period, L Brands had an equity balance of $1.87 billion in 2008 and as of its most recent filing the company reported a $753 million deficit. With a deficit in equity, there is little for the analyst to calculate. And results from calculating profitability ratios such as return on equity ratio become senseless.

When the equity balance is in the red, trying to understand the company's leveraged position by finding the ratio of debt to equity results in silly, illogical numbers. And what a deficit in the equity balance really tells us that if the company was to sell its assets what would remain for the common stock holders is in fact nil.

LB Equity summary of financial results
LB Brands summary of financial results

Instead of reflecting on the peculiar GAAP accounting, of how a profitable enterprise reports on a deficit in the equity balance, let us ask what can we do about it? 

There are two techniques. The first technique is to substitute the equity with the tangible assets of the firm. So to measure profitability for example, we calculate net income in the nominator and tangible assets in the denominator. The same can be done for to find the leverage ratios. Instead of relying on the total liabilities to equity balance ratio, we calculate total liabilities to tangible assets.

The second technique, somewhat more elaborate than the first, evolves around the adjustment of non-cash items such as impairment loss from the reported equity balance.  

Replacing LB's equity with LB's tangible assets

As of the fiscal year end 2017 annual report, L Brands tells us that of its $8.15 billion in reported assets, $3.15 billion relate to Goodwill (the premium paid above fair value price of a company) and $411 million in trade names.

If we remove the two intangible assets, we find assets valued at $6.39 billion, which includes $2.89 billion in property (L Brands owns many of its retail stores) and $3.29 billion in current assets. Using the reported profit of $983 million we find a return on capital of about 15%. We can apply the same technique for the 2016 results and find a return on capital of 18%.

To calculate the company's leverage, we will again remove the intangible assets from the company's reported assets. And with reported liabilities of $8.9 billion for 2017, for every dollar of assets we conclude that L Brands leverages a dollar and 39 cents. For 2016 the adjusted assets were $6.41 billion and total liabilities were $8.90. Again we find that for every dollar of assets, the company used a dollar and 39 cents of debt.

By replacing the equity with adjusted assets, we get a better sense of the company at hand. We can now proclaim: L Brands was able to generate a reasonable profit on its invested capital. But it had done so by taking a surmount level of debt obligations.

LB Brands reported balance sheet
LB Brands reported balance sheet

Adjusting LB's equity    

In 2017 L Brands had retired $1.93 billion of its common stock. To retire the stock simply means that L Brands had purchased its owns common shares in the marketplace. But instead of keeping the common shares, what is classified in the accounting profession as treasury stock, management retired the stock it bought which means it cannot sell the stock in the future. From that naive practice, the retained earnings balance took a hit of $1.93 billion, resulting in a deficit of $1.43 billion. 

So Treasury stock is the second adjustment to reported book value. In If the return on equity is too good to be true, then it probably is ,I showed how to adjust for treasury stock using the balance sheet of IBM and Colgate. I will not repeat the math but instead add back the average cost of the shares that were purchased. We get an equity balance of $2.4 billion in 2017 and an equity balance of $1.96 billion in 2016.

We now see that using the equity adjustment technique the 2017 return on equity was 41% and the 2106 return on equity was 59%. Again these rich ratios are the result of management's appetite for debt. And as any financial institution knows, the more debt the company uses, the higher the return on equity.    

Epilogue

"Proper accounting is like engineering," notes Charlie Munger. "You need a margin of safety. Thank God we don't design bridges and airplanes the way we do accounting."

Not enough investors know and understand that the accounting profession often mandates nonsensical reporting. I think many investors treat the financial records of publicly traded companies as if they are pure, self-evident numbers that follow clear and logical accounting laws. 

Yet nothing could be further from the truth. As a matter of fact, financial records are loaded with assumptions and are full of management’s decisions of how to represent the economics of its business.

My purpose in this meditation is to remind the reader that just as a medical student needs to understand the body's anatomy prior to performing surgery, so must the stock investor understand accounting conventions. And more important, that the conventions are merely the starting point to understand the company’s economic reality. As a wise sage once said: accountants know how to count; investors should know what counts.

Why I Am Long Probiotics

Published on:
August 17, 2018
Last Update:

In Nutrition Made Clear, Professor Roberta Anding tells how important a healthy digestive system is to our overall well being. There are over 4,000 different types of micro organisms in our gut flora and these little creatures boost our immune system and help us to fight bacteria. Mesmerized by her class and teaching style, I also learned that unless we are actively eating fermented food and seeking products that contain probiotics, our modern diet is weakening our immune system.

As I was reading how antibiotic medicine kills these essential micro organisms, Lifeway Foods, a company that fights the war against the modern diet, had appeared on the list of the companies that are trading at a 52-week low. A serendipitous encounter, I thought to myself and downloaded Lifeway Foods’ most recent public filings. I was intrigued to find out more about the company and why the stock price had recently halved in price.

The stock biography

LWAY traded hands as low as $5 and as high as $22 over the past decade. The average stock price range was between $8 to $16 during this time . Compare that to the current stock price of little less than $4. And since the December 2017 stock price of $10, LWAY stock value has sharply declined. 

I attributed the loss in market capitalization to an overreaction by Mr Market due to the 2017 reported loss of $346,000 or $0.02 per share. It was the first reported loss in over a decade.

It does not take a financial wizard to understand why the company reported a loss in 2017. Sales declined from $124 million to $119 million while the cost of sales had not changed (in both 2016 and in 2017, cost of sales were $86 million). And it seems management is slow to change its operating expenses as the general and administrative expenses were $14 million in both 2017 and 2016.

Free cash flow

While capital markets focused on the decline in revenue and reported loss, I looked for the normalized free cash flow. Defined as cash flow from operations less the cost of debt and fixed capital expenditures, the 2017 normalized free cash flow was not materially different compared to prior years. In 2017 management reported on a loss in free cash flow of $1.3 million and in 2013 it had reported an even steeper loss in free cash flow of $2.5 million.

But in 2013, while showing a loss in free cash flow, the company’s income statement reported earnings of $5 million or $0.31 per share. Unsurprisingly - because capital markets focus on earnings per share at the expense of free cash flow - the stock traded hands in the range of $24 and $32 during that year.

But in 2017 the loss in free cash flow coincided with a reported loss in the income statement. This infuriated Mr. Market and consequently the stock price was severely hit.

To me, both accounts are nonsensical. The loss in free cash flow in both years was due to abnormally high capital expenditures and not because of a fundamental change in the business of selling kefir. I estimated that the annual, normal capital expenditures are $3 million. But in 2013 they were $8.5 million and in 2017 they were $5.4 million.

13D filings

Submitted to the SEC within ten days by anyone who has more than 5% of any class of publicly traded stock in a public company, 13 D filings should not be overlooked.

Visit the 13D for LWAY and you will read that the Smolyansky family owns about a half of the outstanding shares of the company. And that in 2017 Lydia Smolyansky, who is the majority shareholder and owns of a third of the company, gifted to her two brothers 1.5 million shares from her own pocket. I viewed that as a positive sign.

LWAY's coverage ratio

LWAY's ability to pay back debt was excellent as of its recent public filling. The cash flow from operations to interest expense ratio was over 15 times. Between 2017 and 2013, the ratio ranged from 15 times to 37 times, a remarkably conservative ratio.

LWAY finances its operations prudently. Over the past four years, the average book value was $48 million, and outstanding total liabilities were $18 million, resulting in debt to asset ratio of less than 40 percent.

The company holds enough cash to pay about 20 years of the current interest payments. A praiseworthy achievement.

Epilogue

"This is one of the most important things you can do to increase your overall health," notes Doctor Ax, a YouTuber. "And if you can increase the amount of good bacteria and balance the level of microorganisms in your body, it can have tremendous benefits. Probiotics are essential to healing any condition out there today."

If you learned one thing from this essay, I hope it is a new appreciation of the gastrointestinal tract and an awareness of our need for probiotics. If you would like to know more about the benefits of probiotics and which foods contain them, I suggest that you read Probiotics Benefits, Foods and Supplements - a Vital Part of Any Diet and 7 Kefir Benefits and Nutrition Facts that Boost Immunity & Heal the Gut.

Another excellent article I found was written by The Academy of Nutrition and Dietetics and you can read an article about priobiotics by clicking here. Doctor Patricia Hibberd of the National Center for Complementary and Integrative Health has a free lecture on the topic.

The one advantage of short term thinking? a cheap stock price

Published on:
May 4, 2018
Last Update:

"The results we report today clearly do not meet our expectations," said Mark Walchirk, boss of Patterson Companies (PDCO on Nasdaq). "They fall short of what we know the business is capable of achieving."

Here are a few disappointing facts: sales were down 2.7% compared to the prior year; gross profit margin declined by 2.20%; adjusted operating profit declined to 36.2%; and the company reported a loss of $49 million in free
cash flow.

Capital markets must have paid close attention to the March 1, 2018 earnings call, because PDCO's stock price  dropped by about 20% shorty after. The stock closed for that day at price of $25 a share, compared to $32 a share the week prior.

Based on the question raised by the analysts, I am guessing Wall Street is concerned with three issues.  First, management is planning to sell private
label products. This is a new, uncharted territory for the firm that may prove to be more expensive than expected.

Second, there is a concern that the decline in operating margin will continue for a long time (Management explained that this was the result of "a change in the sales division and a disruption related to our ERP implementation and sale of digital equipment."). Third, future earnings will be lower compared to past earnings. Management lowered the guidance to $1.65 from $1.70. A faux pas on Wall Street.      

Five-year comparison

Yet on a five-year basis, PDCO showed different results. For the first nine months of this year, PDCO reported on $180 million or $1.94 earnings per share. Compare that to 2013 operations where the company earned $210 million or $2.03 per share.

Put differently, in nine months, the company earned 85% of what it had earned five years prior. Also, in terms of revenue, Patterson sales were slightly over $4 billion compared to $3.6 billion in 2013. And for the is-management-shareholder-friendly-minded reader, total outstanding shares declined to $92.6 million from $103.8 million, a decline of about 10% in outstanding shares.

Let us go back a decade in time and compare the operating results between 2008 and 2013. In 2008 PDCO earned $225 million or $1.69 per share, compared to $119 million or $1.75 per share in 2003.

Total sales in 2008 were $2.99 billion compared to $1.7 billion in 2003. And reported outstanding common shares in 2008 were $132 million compared to $86 million in 2003. In short, the company had done substantially better in terms of revenue and profit but because it had issued a large amount of outstanding shares, on a per share basis, it showed unimpressive results.    

To summarize 15 years of operations:  revenue increased to $5.6 billion from $1.7 billion, an increase of 229%. Earnings increased to $171 million from $119 million, an increase of 43%. And the number of outstanding shares only grew by 10%, to $92.6 million from $86 million.

And a few more praiseworthy notes: the company did not report a single year of loss in earnings; since 2010, it had returned $615 million in dividends (at purchase price of $23 per share, the is over 4%), and PDCO operates in an industry where time is your friend. Read: the need for dental and veterinary products is likely to increase with time. 

The earnings multiple 2017 - 2008

Should the reader need a classic example of the difference between a short term view and a long term view of a business, I believe PDCO serves as one of the best illustrations out there.

Over the past month the stock traded hands at a price between $23 to $22. That translates to about 11 times the reported earnings of $1.94 as of January 27, 2018 (which again only represented nine months of operating financials!). Compare that to period between 2017 and 2013, when the stock traded as low as $32 and as high as $53. During this five-year period, investors happily paid an earnings multiple between 28 times and 12 times the earnings per share.

Or we can go back even further in time and see that between 2012 and 2008, the stock traded as low as $16 and as high as $37. And during the five-year period, investors were paying an earnings multiple between 19 and 9 times the earnings per share. If one were to exclude the years, the stocked traded between $37 to $28 and the earnings multiple ranged from 13 to 19 times the earnings per share.

***

 It is a fact of life that the present dominates our thoughts and feelings. But to become a successful investor to see the long, distant horizon is key.   

Financials metrics are worth more than a thousand words

Published on:
April 6, 2018
Last Update:

Look at the price history of a few companies operating in the shopping mall sector and you will see the ominous outlook for the industry. In 2017 Simon Property Group (SPG) traded as high as $188 and as low as $150. It now trades at $154. Realty Income (O) traded between $64 and $53 during the same period; it now trades at $52 GGP Incorporated (GGP) traded between $26 and $19, and now trades at $20. And Seritage Growth Properties (SRG), a real estate company which I bought last week, traded in 2017 between $50 and $38. It now trades at $35.

Because a loss in popularity is a signal for opportunity, I decided to compare the operating performance of four real estate companies, hoping to find undiscovered insights. And this essay is about what I learned.

Profitability, dividend policy and growth trends

Profitability

With a ratio of funds from operations (FFO) to sales of 72%, Simon Property showed the highest ability to translate revenue to after-tax cash flow. GGP and Realty Income also demonstrated reasonable ratios of 65% and 63%, respectively. Seritage, on the other hand, had the lowest FFO to sales ratio at 51%. The optimist investor may regard the latter as the highest potential for a future increase in the ratio though. 

It was also apparent that Simon Property earned the highest amount of FFO per dollar of equity. In 2017 Simon Property earned or $16.89 FFO per share, using a $17.8 book value and a ratio of 40%. Compare that to Seritage, which generated FFO of $2.48 that year, using a $34 book value, a ratio of 7%. The ratio of FFO to equity book value is important: the higher the ratio the greater the likelihood of an increase in book value per share, which ultimately drives stock value.

Dividend policy

As I write these words, shopping mall REIT dividend yield is higher than the yield the dividend yield on the S&P 500. But is it high enough? Visit bankrate.com and you will find that in today’s capital markets, a certificate of deposit - insured by the FDIC - yields 2.75% for five years. In that light, investors in shopping mall REITs should focus on capital appreciation, not a dividend yield, because the latter can be easily achieved with a simple and much safer certificate of deposit.   

Growth trends

Over a five year period, Simon Property grew its average 3-year FFO per share from $8.29 to $15.94, or 14% compounded annually. GGP Inc. had a 16% growth in FFO and Realty Income had done slightly better, with a 17% growth in FFO. This is a wonderful performance but I am uncertain how much is related to superior management and stellar operations compared to that in 2012 the average 3-year FFO was simply at rock bottom because of the Great Recession. I excluded Seritage from the discussion because the company became available to the ownership of the public only in July 2015

The most striking ratio is the price to book value. Recent investors in Simon Property or Realty Income had no difficulty paying between 10 times and 2 times the book value per share. Can you see their illogical valuation? On one hand, as indicated by the overall price decline for all companies, we deduce that capital markets view the future of owning shopping mall as a tricky business.

But on the hand, recent investors in Simon Property or Realty Income had no difficulty paying a hefty premium for the book value of the companies. In other words, those who invested in Simon Property or Realty Income, implicitly valued the net worth of the companies more than what management had reported.

Three summary points

“The test of learning psychology is whether your understanding of situations you encounter has changed, not whether you have learned a new fact,” said the Dean of Behavioral Finance, Daniel Kahneman. And in that light, I hope what you take from this article is a perspective on how the comparison of companies can serve as a good starting point to understand the relative strength between the companies and the economics of their business model in terms of profitability and leverage. Three summary points: 

First point: the four companies’ use of debt was reasonable. No company had financed its operations with debt greater than 65% of the capital structure. And in the world of real estate, where debt is prevalent and easy to get addicted to, it is a noble achievement. Seritage, in which I bought, had a ratio of debt to assets of 48%, which I expect to increase in time.

Second point: the price investors were willing to pay for a shopping mall REIT was anywhere between 10 times and 21 times the FFO per share. And so, if you are looking to purchase a shopping mall REIT, there has to be a rational reason why you would pay above or below that multiple.  

Third point: financial numbers are a good starting place. But they are never enough. While a review of the price to FFO and price to book value provided some guidance as to the relative attractiveness of Seritage compared to the other three real estate companies, to understand the investment merit behind Seritage, of bringing a portfolio of shopping malls to market rents, you would need to read the annual report. 

Four Things To Understand Before You Buy A Stock

Published on:
March 30, 2018
Last Update:

Don’t you look at the neighborhood in which you plan to purchase a home in? You also probably look for answers to questions, such as: what was the average price for homes in that neighborhood over the past year. Or how long did it take to sell a home. Or how many homes are for sale right now. Or what is the typical size of a home. And is there a plan to develop a large amount of homes in the near future. Outside of the neighborhood, you probably speak with lenders and inquire about mortgage terms.

You intuitively know that the more information you gather, the better decision you will make.

Similarly, when I buy a stock of a company, I try to understand not only the company, but also the economics of the business in which it operates in. I research how much debt the typical company uses, the typical dividend yield investors can expect to receive, and the profit margins in the industry.

I typically start with four or five companies that share a similar business model. And, in this article, I will briefly go over the items I compare between companies.

Capitalization

I start by multiplying the current price of the stock by the number of the common shares outstanding. To that number, I add the market value of the bonds and preferred stock. For example, Seritage Growth Properties (SRG), a real estate company that traded for $35 when I bought its shares last week, had $37 million in outstanding shares (that number includes Class A, B, and C shares). So, the common stockholder capitalization was $1.3 billion.  Add to that $70 million of preferred shares outstanding and liabilities of $1.5 billion. Add all these numbers and you get a total capitalization of $2.87 billion.

Understanding the capitalization structure allows one to see how leveraged the company is. In the case of SRG, the company uses 55% leverage, which to me is reasonable. The rule of thumb is simple: the higher the leverage, the higher the risk of default. Or, as my mother often reminds me, bankruptcy is never declared by those who do not take debt. 

Balance sheet

I also like to look at balance sheet items, such as current assets, net current assets and book value per share. You would be surprised how much these simple balance sheets - publicly disclosed to anyone - can reveal about the economics of a business and the relative strength between companies. If we return to Seritage, as of year end 2017, current assets were $438 million, net current assets were $185 million (a positive number means that the company can pay off its short term liabilities without selling its long term assets) and a book value per share of $35.    

To know the book value per share is important because you immediately get a sense of how much you are paying for the net worth of the company. If we go back to SRG, you can see that the stock traded at about the book value per share of the company (I try to refrain from paying for stock that is priced over two times the book value per share). 

One thing to note is that the reported book value per share often needs adjustments. You can see an illustration of how I adjusted the book value per share of Colgate-Palmolive by clicking here.  

Income statement

Revenue is vanity, profit is sanity and cash is reality - but all three income statement items are worthwhile to look at. Observing trends in revenue gives a better overview of the company than its management’s statements. The profitability allows one to understand the economics of the business and to compare whether the trend reconciles with the revenue trend. For example, if you look at operations of Bed, Bath & Beyond, an American chain of merchandise, you will see that revenue over the past decade increased by 73%, or 5.65% compounded annually. And earnings per share increased from $2.10 to $5.10, 9.3% compounded annually, over the same period. When the two metrics reconcile, you reduce the chances of accounting shenanigans. 

Ratios

No matter how deep your pockets, no one likes to needlessly overpay. And just as you probably know the range of prices for homes in that neighborhood we discussed in the first paragraph, ratios allow us to understand how much we are paying for the stock.

Some of my favorite ratios are: price to earnings per share, price to book value per share, net income to sales, earnings per share growth over ten years and net income to book value per share. While I can easily think of additional ratios (such as enterprise value to EBITDA, or a comparison of every dollar of retained earnings to market value of the stock over a five-year period), starting with just a few ratios often illuminates most of the picture.

Next week

This is part one of a two-part essay. This week I wrote that understanding the financials of four to five companies in the same industry is a good place to start to understand the economics of a business. 

Next week, I will compare Simon Property Group, an American commercial real estate company, GGP Inc., a publicly-traded real estate investment trust that invests in shopping centers, Realty Income Corp., whose headquartered is across the street from where I work, and Seritage Growth Properties, a REIT with a portfolio of 235 shopping centers.