Webinar: How to Use New Constructs' Stock Ratings, Part 2

Attendees are in listen-only mode. Welcome to the New Constructs webinar, our weekly webinar on how best to use our site. This is David Trainer. I'm CEO of New Constructs, and I'm very pleased to be able to be with you all today and explain more about how to use the site. I'm going to jump right into the main topic, which is The valuation metrics of our rating system. But I want to remind everyone, if you have questions, send them in anytime. I think you can type questions into the interface here for the webinar. Email us at support@newconstructs.com. Hit us up on Twitter, Facebook, LinkedIn. We want to know what you think, and we want to answer questions. We've got a really great system here, and we want we want you to be able to see and understand everything. As much as possible. So most people know to get into the site and to get ratings, you got to click the login page. Logging in, very simple, just like any site. And once you're in and you want to get into ratings, right, there's 2 ways to do that. Institutional members have the ability to just kind of look at ratings one-off because they tend to oftentimes look at lots and lots of companies. Other members, you can do it out of the portfolio page, right? So if you've got a portfolio You can easily copy and paste in a bunch of tickers, type in a bunch of tickers, etc. You create new portfolios very easily, right? Add tickers as much as you want to them, as often as you want. So if we wanted to add those Tickers in here. By the way, this is our most recent, most, uh, very— or danger zone call. Anyway, so when you— whether you have one ticker in here, you've got 50, you click on this icon to get more information about the rating, right? There it is. Last week we talked about quality of earnings. We believe that our quality of earnings analysis is the best in the business. Nobody does more work in closing accounting loopholes and giving you the best possible measure of profits and return on invested capital in the business. I've been doing this work since the mid-1990s. That's back when annual reports were only 20 or 30 pages. And let me tell you, it was a lot easier back then. It's only gotten tougher. And look, having worked with FASB and the XBRL people, it's only going to get harder. And it's clear that companies are not in the business of being transparent. So, we talked last week about economic earnings and ROIC. This week, we're going to focus on valuation. So, we use 3 valuation metrics. And all 5 metrics that go into the overall rating are equally weighted. And we have 3 valuation as opposed to 2 quality of earnings because, well, frankly, a good company is not always a good stock. A bad stock is not always a good company. And so, the point is, Even if profits are really good, if valuation is high, well, that should override the day. The stock should still get a bad rating. A perfect example of such a stock— good company, not good stock. In fact, I would say good company, very bad stock— is Netflix. We throw that into the, into the ring here. And what you see here is good quality of earnings and then a really high valuation. Anyone who's heard me on CNBC recently or heard other podcasts, Netflix is the poster child for overvalued stocks. And a lot of people say, well, David, you know, it's over— it's been overvalued for a long time. You said it was overvalued a year ago and it keeps going up. Well, it's gone down some. It's obviously gone back up here recently. But they make a good point. I remember having a great meeting with some of the institutional ETF builders over at Merrill Lynch. And one of the really astute people in the room said, yeah, David, Netflix is expensive because I pointed out to justify $450 a share, they had to grow profits at something like 15% compounded annually for 20 years. And he said, yeah, that's overvalued, but it may get more overvalued. And I said, that's right. Sometimes the markets are irrational. And he said, yeah, sometimes there's no limit to the irrationality of the market. And I said, yes, that's true too. But I believe there is a limit to the amount of risk people want to put into their portfolios. And that's what we're talking about a lot of times with valuation. This is a transparent way to measure risk. And too often, the conversation about risk has been turned upside down these days. Too much Cramer, too much CNBC, too many people pushing stocks for the sake of pushing stocks. And I remember when I was on CNBC and I brought up the valuation of Netflix at $550, implying something like 20% compound annual growth in profits for over 20 years and how that implied something like 2.5 billion customers, that they were going to achieve 2.5 billion customers at $8 a month. And the guy on the other end, or my opponent on the show, because it was a bull versus bear segment, Said, yeah, but profits don't matter. And that's true in the short term. But I do think risk matters. And I think when you're thinking about your clients' portfolios and you're having a conversation with them about a hot stock, and they're pushing it, or you're thinking about looking into it, I really highly recommend think about the risk. Because at some point in time, I believe the music stops for Netflix unless there's some drastic and incredible change in their business model. And if you think that it's possible for them to grow that fast, I got one stat for you. And whoever can guess what my major stat is by typing it into this, to the question and answer session here, or the chat session, gets a free copy of our next special offer. I'm going to give you 5 seconds. 1.5 million. Oh, a couple good guesses. No, no correct answers. The key stat, all that growth that Netflix is getting is on the international side, right? They're almost fully penetrated on the domestic side. It's all international. Anyone know what the international margins are? Negative 15% or worse. So they're not making money on those. So we're talking about valuation. 3 metrics here, free cash flow yield, the price-to-economic book value, and the growth appreciation period. Free cash flow yield, that's simply free cash flow divided by enterprise value. And that's free cash flow to all stakeholders. And enterprise value is the value of the entire enterprise based on all funding sources. So that's trading— traded stock, that's stock related to unexercised options. That's a special adjustment we make. That's That's on-balance sheet debt. That's the off-balance sheet debt we talk about. That's preferred stock. It's everything. Everything. Net excess cash, right? And the free cash flow is the free cash flow to all stakeholders. And we look at all stakeholders because it makes— it's the most apples-to-apples number. If you change free cash flow to be focused only on one particular constituent, say for equity guys, Well, there are going to be distortions inherent in the ratio based solely on the company's choices around financing. Highly levered companies are going to look extra worse on— extra bad on free cash flow versus the companies that are not as much levered simply because of their financing decisions. And it may be very smart for that business to be highly levered because it's a cheaper cost of capital and they're making a lot of money. Financing decisions can affect your measure of the operations. And we always, in what we do, like to separate the financing decisions away from the operational decisions. We want to know how much business to make money— the business is making despite its funding strategy. Now, funding strategy affects the cost of capital, but that's, again, that's a financing discussion. So free cash flow, unlevered free cash flow over enterprise value. Now, the price-to-economic book value is one of my favorite metrics in the world when it comes to valuation. The economic book value, or EBV, is the book value of the business based on its cash flows. Net operating profit after tax divided by the cost of capital, plus cash minus debt divided by shares outstanding. That's a very simple version of the formula. I'm going to show you before we're done with this webinar how to get official definitions of everything we talk about, because we— those are, those are all over the place, easy to access. But I want to give you the overview of what they mean. So price to economic book value. The economic book value is the value of the business based on its existing cash flows. So if cash flows stay the same forever or effectively decline at the rate of inflation and the business never grows profits again, That's the economic book value of the business, the no-growth value of the business. So when we create the ratio price to EBV, what we're showing you is the ratio of the stock price to the economic book value per share. So when the ratio is 1.0, that means the stock price equals the economic book value, which means the stock price is discounting No growth in profits. If the price-to-economic book value is 2.0, then the stock price is discounting a doubling of profits over the remainder of the company's life. Now, it's actually looking for the company's profits to be a little more in nominal terms than twice because the present value of future profits is 2.2 times the stock price. So that's a sort of minor nerdy mathematical calculation terms here, but you guys know I'm a big nerd and I'm not going to let anything slip. So if I do, send me an email or ask me a question and, and, uh, I'll make sure and get that corrected. I've done these calculations for so long, uh, that Even the nerdy stuff doesn't even seem that nerdy for me. So, all right, I'm getting off track. Growth appreciation period, my second favorite metric of all the things we do. Whenever you see 101 here, that means that the valuation of the stock breaks our 100-year discounted cash flow model, or it goes beyond 100 years. Okay. So the growth appreciation period is technically also— it's also known as the competitive advantage period. The technical definition is the number of years that a company grows its profits. The number of years that a company can grow its profits. Another way of saying it is the number of years that a company can earn returns on capital above the cost of capital. On new investments. Think of it— think of this as the numerical value to measure the market's belief in the width of the moat, right? You hear a lot of people talk about moats. Warren Buffett talks about— he created the analogy, the moat around the business. Some of our competitors use the term moat. They don't quantify it like we do. The quantification of the moat is in the growth appreciation period. And what we're showing you is the market implied width of the moat for the company. That's the number of years that the company's going to be able to stave off competition and grow its profits. Now, for Netflix, it's 101 years. All right, it's huge. I'm going to go into a little detail about how crazy Netflix's valuation is when we go behind the numbers here. But first of all, whenever you see 101 here, red flag. That's why it gets our very dangerous or very risky rating here. It's more than 50 years on growth appreciation period. That's bad, my friends. Okay. The price-to-economic book value ratio of 13.1. If we had a chart, that number would be off the chart. All right. And we actually do have some charts on this stuff that we provide on some custom dashboard for some of our institutional clients. But yeah, 13.1, that's big. That's why you're the dark red here. That's a really big number. Free cash flow yield, negative 1.4. It's not horrendous. We've seen a lot worse. Still not very good. Gets our dangerous rating. So, 2 out of the 3 valuation metrics get our very dangerous rating, while the quality of earnings metrics are pretty good for Netflix. The return on invested capital has come up. The economic earnings are actually finally positive and rising. I think this is First time in many years, so that's good. And hopefully you've noticed, as I've been pointing out here, you get the actual values here behind the rating standing. So these are sort of where the companies, where individual company values stack, right? Very attractive, attractive, dangerous, very dangerous, dangerous. That's where they rank amongst all companies. The actual values behind that. And if you want to benchmark any individual company's values to the S&P or the Russell 2000, that's down here, right? So, the return on invested capital for the S&P 500, 21%. The free cash flow yield is 2.2%. The price-to-economic book value for the S&P 500, 2.2, neutral, right? 22-year growth, market implied growth appreciation period. All these are meaningfully lower than where Netflix is. Netflix is even worse than the Russell 2000. It's got a 4.2 price to economic book value, and it has a market implied growth appreciation period of 52 years. Note that these benchmarks are based on actually ETFs because we get ETFs that tell us exactly, that reflect exactly The S&P 500 and the Russell 2000. And so this is a, you know, a quick plug on our mutual fund and ETF research. We show the same values and rating system for mutual funds and ETFs as we do for stocks. That's what makes our mutual fund and ETF research special. So if you want to get details, more details on anything about our ratings, click right here on this link, Ratings Methodology. That'll take you to our stock rating methodology page, and you'll see here that we base that rating on the 2 things: quality of earnings or business strength, right? And you want more detail on the economic earnings versus reported earnings—that's the first quality of earnings item here—you click here, and this goes into a very lengthy discussion on the comparison between economic. And accounting earnings. I've been talking about economic versus accounting earnings for about 20 years now. And it's truly a topic that sort of never gets old because despite all the market ups and downs we've had, people still aren't that aware of it. And I think CNBC, Wall Street, they do a good job of keeping people focused on what makes it easiest to sell stock. And I'll tell you, it's not looking at economic earnings. Return on invested capital. That's a very simple calculation. NOPAT divided by invested capital or average invested capital a lot of the time. And the key thing, yeah, ROIC is easy if you get the NOPAT and invested capital values right. And we've got details on those calculations as well. Look, we'll show you the formula. We're happy for you to see the formula. We're happy to see white papers on all the adjustments we make. And we absolutely welcome you to calculate it on your own. Trust me, I used to do this manually in Excel models. And I did it on thousands of models. When I was global— when I was head of global forensic research at Credit Suisse, I built more NOPAT models in Excel than probably anyone will ever have the misfortune of having to do again. Yeah. And I know that you may do it once, and then you would be very happy to pay us handsomely for us to do it for you, because you will, number one, realize how much work it is, and then number two, how difficult it is. Back to the ROIC calculation. Also, we'll show you our definition of NOPAT— I'm sorry, invested capital. A lot of times you'll see that we do these calculations of NOPAT invested capital from both a— Operating and financing perspective, they they both equal each other. It's just another nerdy way for us to show us how good show you how good our calculations are. Here are all the adjustments again. White papers on adjustments as much as you want. You know, there's certain adjustments you can't get any place in the world, like right asset write downs, mid-year acquisitions, unrecorded goodwill. You know, I had the guys famous guys who wrote a lot about a three letter version of what we do here. EVA, who basically tried to bribe me into giving them access to some of our adjustments so they could make their methodology better. And I didn't. And they're relying on Compustat and their clients are therefore at great risk. So those are the definitions on the quality of earnings side. And we should get quickly to the more important definitions, which is on the valuation side. And they're right here. So, free cash flow yield, price-to-economic book value. So, if you ever are curious, like, okay, first of all, all of our webinars are recorded. And sure enough, I got a question here. How do we ask questions when we're not on a webinar? Well, we can't be having a live interaction. Email us at support@newconstructs.com. Hit us on Twitter at Twitter at New Constructs, LinkedIn, Facebook. Ask a question anywhere; we'll get back to you. You're you're welcome to email me david.trainer@newconstructs.com. I may not be able to be as responsive as our friends at support@newconstructs.com, but. Look, we're open books. And you can see here, free cash flow. It's basically free cash flow yield. First of all, free cash flow is NOPAT minus the change in invested capital. Free cash flow yield is free cash flow divided by enterprise value. Oh, you want to understand how enterprise value is calculated? We'll just click there and we'll show you that. Market cap plus total debt minus excess cash minus unconsolidated subsidiary assets. Minus the net assets or liabilities from discontinued operation. Add the value of outstanding stock option liabilities. Add underfunded pensions or subtract overfunded pensions. Add preferred stock. Add minority interest. Subtract out the net deferred compensation assets. Subtract out net deferred tax assets. For a lot of these companies, when I'm talking about NOPAT, I'm talking about invested capital, I'm talking about enterprise value. Sometimes these adjustments don't matter. Sometimes they matter a lot. And a lot of the reason you haven't heard more people in research talk about all these adjustments is because it takes so much time to do this work that they just like to pretend they don't have to do it. And so adjustments really don't come up much. We even have a special slide here we created that talks about Free cash flow and how our approach to free cash flow compares to traditional approaches. You can take cash flow from operations and subtract CapEx to get to free cash flow. That's a quick and dirty way, and we sort of show a progression towards what it is we do. Again, no pat minus the change in working capital minus the change in free fixed assets, which includes CapEx less depreciation. And acquisitions plus divestitures equals free cash flow. So anyway, there's that definition. The price-to-economic book value definition is here. We put this in the context of Walmart. We wrote an article quite a while ago, The Blue Light Special on Walmart, back in June of 2011. Clients who followed that advice were very happy. And— or were very happy if they invested based on that advice. Formula for economic book value, NOPAT divided by WACC. And then here are all the adjustments again. Sort of a mirror image of what you see on enterprise value. This is part of what you need to do in order to convert cash flows or valuation calculation to something that reflects only the equity holder stake. Versus what reflects all constituents. And then on the growth appreciation period, the growth appreciation period, as I've said, is the number of years a business is expected to earn an ROIC greater than WACC on new investments, also known as the CAP competitive advantage period. This is, you know, this when it comes to modeling is a fairly unique approach. Most everyone else wants to put everything into a 5 or 10-year DCF. And the problem with a 5 or 10-year DCF, my friends, is that you're forcing the competitive landscape, the competitive future of every company you look at to fit within a 5-year timeframe. Well, we all know that doesn't work. What's the solution? Well, I can tell you the solution. Oh, we got some bad figures here. I apologize about that. The solution is using a terminal value that assumes future growth. And let me tell you, the time I saw on Wall Street, terminal value was the wizard behind the curtain that made any analyst's DCF model. And by the way, I'm talking pre-1998 because after 1997, '98, Nobody used models on Wall Street. Okay, I'm not kidding. I was at Credit Suisse, which was the heart of the tech bubble, right? Frank Quattrone was at our firm. All right, when you're getting paid $50 million per IPO that you get done, um, you know, you don't have time to build models. You're just out there trying to figure out how to quickly, most quickly allocate this model or write a research report that's going to get more people to buy. Anyway, the terminal value had a perpetual growth rate assumption and still does in any DCF model you see out there outside of ours. Ask them what their perpetual growth rate assumption is. Perpetual growth is that growth beyond that 5-year period in the DCF. And the problem with that kind of assumption, and we do, we show this in our training. And by the way, we're offering seats in our training for this summer. You get to sit through the same training we give our analysts. We'll show you how to build a dynamic discounted cash flow model. We also show how hugely and disproportionately impactful the terminal value becomes on the valuation equation when you have a perpetual growth rate assumption. It effectively assumes infinite returns on capital. So we do not use a terminal value that has perpetual growth. It is a no-growth terminal value. So, the way our model works is instead of looking at just a 5-year timeframe, we look at many years. And we highlight the year in which our DCF model calculates a value that equals the current stock price. So, instead of saying, well, I got 5 years for my model here, I got to make make that work, we say, well, if we don't get a value that we're looking for in year 5, year 6, year 7, whatever year, we go out another year. We give them another year of growth. And the reason we built a model that's 100 years long is because when I started this business, this work in the mid to late '90s, we had a 25-year model. And as we approached the tech bubble, almost no companies fit in the 25-year model. All my results were 25 years plus. So, when I decided to build another model, I thought about 50 years and I thought, well, you know, I've been through this before. 50 could get tested. Shoot, let's just make it 100 years and that way, no one will ever accuse me of having a model that's too short. So, that's the story there. So, those are the key metrics, the definitions. Now, the education section. Is also a great place to look up metrics. There's metric definitions again, all in one spot, quick and easy to get all of these same details all in one spot, quick and easy. Uh, the, the education section obviously is, is an awesome section, um, for you to learn a lot about new constructs. We've got all of our rating methodologies All our metrics definitions here. There's all the ones we talked about today: price to economic book value, free cash flow, growth appreciation period, value investing. We just talked about investing versus speculating. A lot of good stuff we've done over the years. How to close the loopholes and what all the loopholes are. These are white papers. I think there's 30 plus of them talking about all of the adjustments we make. And I can tell you. Based on experience. A lot of these adjustments are completely unknown to regulators, to the accounting standard setters, and to most investors. We're giving you definitions for free and access to a lot of research for free that's better than what the top regulators, top standard setters, and some of the top investors in the world actually use. And it's because we've got technology. That has allowed us to create a paradigm shift in the typical trade-off between the depth and quality of research. We are a paradigm shift there. We're able to provide an unprecedented level of depth across a large number of companies, ETFs, and mutual funds. And that's why I believe we have some of the best research in the business. And that's why as markets have become a little more risky and not just going up and people no longer believe that Charts work well all the time, and they start to think about diligence. They start to care about risk, start to make, you know, wonder when the music might stop on stocks like Netflix or any other stock. Or they're even afraid that maybe the regulator's looking over their shoulder as the fiduciary responsibilities are looming on the horizon. How do I justify having a stock like Netflix or anything that New Constructs rates as dangerous? How do I justify having that in my portfolio? So, as these questions loom larger in people's minds, new constructs is becoming more and more interesting. And we think that's a good thing. We think it's time that a more constructive dialogue around risk is had with clients. And we think more and more people want to have that. And I can tell you from experience, hand on heart, Our advisor clients make a lot of money impressing— by impressing their prospects and their existing clients because they have new constructs. Whether you're a wirehouse guy and you want to be able to show people that you're not just using the same old model portfolios as everyone else, or you're an independent and you want to show that your independence has allowed you to find some of the best research possible on stocks, ETFs, and mutual funds, It's going to help win you business. And if you don't believe me, you can check it out in the testimonial section of our website. This guy right here does a terrific testimonial for us, been a longtime client. In fact, one of the people who really pushed me pretty hard to get into providing this research to advisors. Because at first, our prices were just too high for advisors. And I think Charles did me a real favor, did me a real service by providing a simpler product and something that could give advisors access to this. Because the more I thought about it, the more I realized that this is actually the most useful product. It's even more useful for advisors than it is just about anybody else. Anyone who's who's constrained by the amount of time that they can spend building models, we're an awesome service. The amount of time you can spend reading an annual report, we're an amazing service because we can give you in an instant ratings on thousands of stocks. Okay. I'm going to pause. I got a couple of questions in the queue here. We like to end these things at about 30 minutes. So, we're running a— we're going to be running a little bit over. So, if you have any questions, get them in right away. I can't promise we're going to get to them all, but I will get to a couple of them. Where else can we find New Constructs research? If you're not aware already, we've got tons of stuff on the investment research of our site. You can also find us on USA Today, Barron's, CNBC. So, for example, You know, we've been— our research was featured recently in Barron's, I think just last weekend, Athena Health. A columnist there featured our research. Well, that link— that's Athena— that's the Athena Healthcare link. Yeah. So, Barron's recently featured our research. Here's the actual link. Sorry, I'm not so good at using my own site. This is the article from Barron's where Vito Raccanelli, one of the top columnists at Barron's, featured our research probably like for the 10th time in the last year. So, you can see our research on Barron's. You can see it on USA Today a lot. Actually, you know, I can— quick way to see where we are in the news. You know, here's USA Today. Look at all these features just in the last few weeks. CNBC on Disney. I was also on CNBC talking about Netflix recently. Guru Focus, Barron's, Forbes, MarketWatch, Motley Fool, First Business, MarketWatch. You go through here over the years, we've been everywhere. So you can— the answer to the question is that if you want to see it on a new— if you want to see in other places besides Investment Research, check out the media, Seeking Alpha, StockTwits, all the major places. Next question: How do we learn more about accounting? Great, that's a great one. I would check the education section of our site, read about accounting loopholes, you know, because my approach to accounting And I'm not a CPA, or I'm not an MBA. And frankly, you know, I did study accounting in college, and I did have to learn a lot about accounting. But you don't want to get too much caught up in accounting because accounting at the end of the day is just the vocabulary in the equation or in the discussion about stocks. It's the vocabulary. The language is finance. And just like Any conversation, you can't do it with just words alone. The words have to be put together in a way that makes sense. EPS is like having a conversation by saying football. It's one word. What does that mean? You could love football, you could hate football. You could be talking about the draft tonight. You know, you have no idea what that one word, what that one metric means, and it has been exploited to the nth degree as the one metric to focus on. When analyzing stocks. Why? Well, it's easy. Everybody wants one thing to focus on. Number 2, it's a whole lot easier selling stock when you get people to focus on a metric that you can manipulate. I was pretty young when I went to Wall Street, but I learned very quickly that investment bankers were excellent at creating new metrics. They could find a metric to make any deal look good. True story. Within a week of Frank Quattrone's technology team joining Credit Suisse, our everyday, our regular Monday morning calls, the dialogue shifted quickly from— and I'd actually gotten like 75% of all the analysts around the world to focus their research on return on invested capital. We did a very good job of convincing people. We had a great model that worked. We were using it globally. I convinced all the analysts. I had all the accounting adjustments fixed for them. And that's what we talked about. When it came to pitching stocks, conversations revolved around return on invested capital. Not long after the tech guys came— well, immediately— they went straight to PE. Then it went to price to revenues. Then it went to price to clicks. Then it went price to eyeballs. And they did deals based on price to eyeballs. That's not proof that bankers can find a metric for any deal. I don't know what is. Okay, we are 5 minutes over. I'm going to cut it off there. Thanks very much to everyone for joining today. It's a great pleasure. We're going to do this every Thursday at 3 o'clock. Be on the lookout. And if your question wasn't able— we didn't— we weren't able to get to your question today, Then I will be happy for to answer any email. Again, support at newconstructs.com, david.trainer at newconstructs.com. And if at any time you're interested in getting access to the webinars, they are on the website. We record them all, and I'm actually not exactly sure where they are on the website. I'm gonna I am. Andre, our head of publishing. Oh, they're under tutorials. Okay, so all the webinars are right here. So here's our webinar from this week, um, how to pick good stocks. That's our first webinar, and they'll all be listed here. And we'll make sure that the titles have the actual date in them so you know what this week is 2 weeks later. But this webinar will be posted probably easily within 24 hours or so. Tomorrow it'll be posted on the site and you'll have access. So, if you don't get it live, you can get it recorded anytime. Thank you for showing up. Thank you for being with us. Ask us questions anytime. We want to be transparent. We want you to know how much work we do for you. Thank you.