Streetwise

Lauren Rudd

Sunday, June 16, 2013

Emotions Can Be Expensive

A few days before the market crashed in October of 1929, Irving Fisher, a well-known monetary economist, confidently predicted that, "Stock prices have reached what looks like a permanently high plateau."

For months subsequent to the crash, Fisher continued to assure investors that a recovery was just around the corner. Unfortunately, he was blind-sided by his own biases.

Letting your emotions or personal bias drive your investment strategy can be an expensive mistake. Let me offer a more profitable approach. If a company has strong fundamentals, a solid business plan going forward, astute management and you understand the company’s business philosophy, then buy the shares and hold them with the understanding that the shares will fluctuate in price, often in sync with but to a lesser degree than the overall market.

Furthermore, companies are often at the mercy of speculators and short-sellers, not to mention the capricious opinions bandied about by analysts. The result again is short-term volatility, often in conjunction with a share price decline. The antidote is always an inherently strong set of financial fundamentals.

For example, there has been considerable commentary of late about Best Buy, a company whose share price has more than doubled in the past six months. Nonetheless, opinions regarding Best Buy’s future are pretty much split between bankruptcy and a new awakening, so let me add a little fuel to fire. My intention is not so much an indictment or defense of Best Buy. Rather it is to make the important point that analyzing a company requires more than a cursory look at few numbers.

For instance, the quick ratio and the current ratio are often used to ascertain the liquidity and therefore the ability of a company to meet creditors’ demands. Both ratios utilize current assets divided by current liabilities. (Note: Current assets, such as marketable securities, are converted to cash and used to pay current liabilities in a 12-month period.) The quick ratio does not include inventory as a current asset, whereas the current ratio does.

These ratios for Best Buy at the end of Q1 were 0.53 for the quick ratio and 1.17 for the current ratio. The quick ratio would, at a cursory glance, indicate that Best Buy had half the short-term assets needed to meet current liabilities, whereas the current ratio told a different story.

The key factor here is inventory turnover (cost of goods sold divided by average inventory). Fast turnover means increased liquidity. In its last fiscal year, Best Buy’s turnover was 5 times, meaning inventory stayed around for about 2.5 months. Wal-Mart’s current ratio was 0.83 in its last fiscal year; however Wal-Mart turned its inventory over 8 times during the same period. Inventory turnover equates to increased liquidity.

No one would argue that Best Buy has had earnings difficulties. Some have interpreted negative net income to mean that not just the dividend is in danger but the Company itself. I could easily argue against this point. The real key is free cash flow, or free cash flow to the firm. In fiscal 2013, which lasted only 11 months, Best Buy recorded a free cash flow of about $800 million and paid out only $224 million in dividends. Net income turned negative due to non-cash write offs and impairment charges. Once these are backed out Best Buy has been consistently profitable.

There is also a question of debt. At the end of 2007 Best Buy had a total debt of $816 million. At the end of Q1 this year that debt has grown to about $1.69 billion. Yet, at the end of 2008, debt was $1.96 billion. So, debt has been decreasing.

The per share intrinsic value of Best Buy using a discounted free cash flow to the firm model is $56, as compared to a recent share price of $26.88. My estimate is that Best Buy will earn $2.15 per share in its current fiscal year and I have a 12-month share price projection of $31 for an annualized return of 10 percent. There is also an indicated dividend of 2.50 percent.