HOW-TO evaluate the work of company management?

1 cze 2023

In my previous post, I told you about the general approach behind the creation of the Fundamental Strength Indicator and what it looks like. In this guide, we will consider the methodology for its calculation and several examples of fundamental analysis of companies, performed using the indicator. But I would like to start with a story.

One day, when I had already grasped the concept of the Fundamental Strength of a company, I was returning home from vacation. I was in a taxi and the driver was listening to an audiobook. As the drive took longer than an hour, I had nothing to do but listen to the story. I liked the content. It was a fictional novel with a plot centered around the main character named Alex Rogo. He is a manager of one of the three enterprises of the UniCo corporation.

Even though Alex spends all his time and energy on work, things are not going very well for the company: over the past six months, the company has only had losses. This leaves Alex's executives no choice but to give him an ultimatum - if he can’t radically improve the situation in three months, the enterprise will be shut down and he will be left without a job. At the same time, Alex's wife is tired of her husband’s absence in her personal life, so she decides to leave him. Anyways, the story's beginning turned out to be very dramatic and I was wondering how Alex would cope with all this.

Luckily, in this stressful time, he meets his former physics teacher Jonah, who now consults companies regarding efficient production. Alex tells his old acquaintance about what’s going on and how he managed to increase labor productivity at the enterprise after purchasing new robots. However, the losses continue to hang over his head like the sword of Damocles.

After listening to Alex's story, Jonah wisely suggests that the problem with his enterprise lies in the management is concerned about anything but the main goal of their business, which is creating money or profit.

Jonah explains to Alex that all management ideas related to expanding the sales market, using new technologies, or improving product quality can lead the company to a disaster if fundamental things are not taken into account. In his opinion, management should only focus on three indicators:

• Throughput, which is the rate at which a company makes money through sales.
  
• Inventory, which is all the money invested by the company in assets: premises, equipment, patents, raw materials, etc. - that is, in something that can then be sold.
  
• Operational expenses, which are all the money a company spends turning investments into cash; or something that can’t be sold, such as the salary of employees, the cost of rent, payment for delivery services, etc.
  

Thus, the management’s job is to make improvements that will ultimately lead to an increase in Throughput and a decrease in Inventory and Operational expenses.

For example, Alex’s purchase of robots in order to increase the number of products produced has led to an increase in production. However, suppose you look at it through the prism proposed by Jonah. In that case, we actually have the following picture: Inventory has increased, Operational expenses have not decreased (no one has been fired), and the robots can’t contribute to sales growth in any way (the Throughput is not increasing). As a result, this was not an improvement, but a deterioration.

The accumulation of such bad decisions eventually leads to the unprofitability of the company. Conversely, continuous improvements that will increase the Throughput and reduce Inventory and Operational expenses will inevitably lead to achieving the main goal – making money.

After I got home, I tried to find this book on the Internet. It turned out that it was written by physicist and philosopher Eliyahu M. Goldratt back in 1984. The novel is called The Goal.

That’s when I realized that if the company's management adheres to the approach described by Goldratt, then after a while, we will most likely see a fundamentally strong company. And the Fundamental Strength Indicator clearly shows how much the management has succeeded along this path.

For example, according to Goldratt, an increase in Throughput should lead to an increase in Earnings per share (EPS) and Total revenue.

The reduction in Inventory may be linked with a decrease in Inventory to revenue ratio.

Optimization of Operational expenses will definitely reduce the Operating expense ratio multiplier.

All these parameters are considered when calculating the Fundamental Strength of the company. So, let's move on to the methodology for calculating the Fundamental Strength Indicator. The main idea that inspired me to create this indicator is: "Even if you buy just 1 share of a company, treat it like buying the whole business". Guided by this approach, you can imagine what kind of business an investor is interested in owning and simultaneously determine the input parameters for calculating the indicator.

For me, a benchmark business is:

• A business that operates efficiently without diminishing the return on shareholders' investment. To assess the efficiency and profitability of a business, I use the following financial ratios (*): Diluted EPS and Return on Equity (ROE). The first two parameters for calculating the indicator are there.
  
• A business that scales sales and optimizes its costs. From this point of view, the following financial ratios are suitable: Gross margin, Operating expense ratio, and Total revenue. Plus three other metrics.
  
• A business that turns goods/services into cash quickly and does not fall behind on payments to suppliers. The following financial ratios will fit here: Days payable, Days sales outstanding, and Inventory to revenue ratio. These are three more metrics.
  
• A business that does not resort to significant accounts payable and shows financial strength. Here I use the following financial ratios: Current ratio, Interest coverage, and Debt to revenue ratio. These are the last three parameters.
  

(*) If you want to learn more about these financial ratios, I suggest reading my two articles on TradingView:

Financial ratios: digesting them together
What can financial ratios tell us?

Next, each of the parameters is assigned a certain number of points based on its last value or the position of that value relative to the annual maximum and minimum.

For example, if the Current ratio:

• greater than or equal to 2 (+1 point);
  
• less than or equal to 1 (-1 point);
  
• more than 1 but less than 2 (0 points).
  

Or for example, if Diluted EPS:

• near or above the annual high (+2 points);
  
• near the annual minimum and below (-2 points);
  
• between the annual maximum and minimum (0 points).
  

And so on with each of the parameters. As a result, the maximum number of points a company can score is 15 points. The minimum number of points a company can score is -15 points. These levels are marked with horizontal dotted lines: the green line is for the maximum value, and the red line is for the minimum.


I track the number of points for each day of a company's life on a three-color Histogram. The resulting average value for the last year is on the Blue Line. For me, it is the last value of the Blue Line that determines - this is the actual Fundamental Strength of the company. As an additional filter, for example, when comparing two companies where all other conditions are equal - I use the dynamics of Cash flows expressed in Diluted net income. These are the thick green, orange, and red lines over the Histogram.

Examples:
Below I will evaluate various companies using the Fundamental Strength Indicator.

Tesla, Inc.


The indicator shows that since 2020, Tesla Inc. has been steadily increasing its Fundamental Strength (from 3.27 in Q1 2020 to 12.79 in Q1 2023). This is noticeable both by the color change of the Histogram from orange to green and by the rising Blue Line. If you look in detail at what has been happening with the financials during this time, it's clear what meaningful work the company has done. Revenues have almost quadrupled. Earnings per share have increased 134 times. At the same time, total debt to revenue fell almost 10 times.


Keurig Dr Pepper Inc.


The company, formed in 2018 by the merger of Keurig Green Mountain and Dr Pepper Snapple Group, has failed to deliver outstanding financial results, causing its Fundamental Strength to fall from 4.63 in Q1 2018 to -0.53 in Q1 2023. During this period, the drop in diluted earnings per share was accompanied by higher debt and deteriorating liquidity.


Costco Wholesale Corporation


Wholesaler Costco has been surprisingly stable in its financial performance and with steady growth in both earnings and revenue. This is the reason why the Histogram bars are exceptionally green throughout the calculation of the indicator. The Fundamental Strength has not changed in three years and is high at 11 points.

In my next post, I will talk in more detail about the dynamics of Cash flows, which can also be seen using the Fundamental Strength Indicator.

See you!