Calculation of Capital Employed from published balance sheets

[Itsallaguess]

I do not bother with stuff like interest cover That will be fine in a well run company and I am not here to try to second guess the directors. Without trying to be too clever one could see the recent problems a mile away without any great analysis. The culture in Carillion was all wrong as it was at least as obviously in RBS, HBOS and so on. No analysis required.

That is why I am slightly concerned about the OPs. They are spending a lot of time worrying about the technicalities and may not be able to see the woods for the trees although I would not want to decry their studies. Just that they are not the be all and end all. Far from it.

I think it's fantastic and really refreshing to see Matt and Mel come to this website really quite recently, and to see them trying to really get to the bottom of some of the key issues that investors face. I really do wish that I'd had such enthusiasm when I started out, and I envy their keen eyes at such an early stage, which seems to have given them a real ability to get down into the weeds and examine some real gritty stuff.

Simoan has kindly linked to a book that tries to demystify company accounts earlier in the thread, but unfortunately there doesn't seem to be a book available to 'Demystify business culture', so this is all a bit of a grey area for someone who might lack the ability to easily see through the 'culture' of a company (without using any hind-sight bias, of course...), so whilst your own results using whatever approach you use are clearly admirable enough Dod, it doesn't really help anyone if they themselves would also wish to learn the same soft-skills...

I hope Matt and Mel also decide to take a close look at Free-Cash-Flow after they've got as far with ROCE as they wish to, as I think their forensic methods will be great if they choose to cover a FCF subject that we've touched on a few times ourselves over the years.

Cheers,

Itsallaguess

[Dod101]

Matt and Mel

You learn (hopefully) from your mistakes. We have all made them. Were I you I would be reading the broader issues at least first so that you have a good idea about the investing world and leave what I would call the technical analysis for now. But fundamentally you need to know (you probably do) what are your aims, income, long term capital growth or what. As you will have gathered I am a bit sceptical of too much technical analysis. Find a good company from its 'feel', how the Annual Report reads, as I said whether it has a family influence, is it long term in its outlook and stuff like that.

I think an appreciation of the environment in which it operates is important. I have not touched retail shares for a long while, see the M & S results due out tomorrow. They may be fine but who knows? The High Street is changing radically and sales are moving/have moved online.

I am not in the least knocking what you are doing though because you are no doubt improving your financial education no end and that will stand you in good stead.

Dod

[CryptoPlankton]

I think of investing as much more art than science, but each to his own. I do not try to analyse Balance Sheets.
Dod

I don't often analyse balance sheets either and prefer to use a reliable data source to extract the numbers that I need. It's always worth cross checking with the company accounts though if something doesn't look right. Everybody will have their own approach. For instance, I rarely look at P/E or dividend yield when deciding on the investment merits of a company, and prefer to use metrics that are less open to manipulation by creative accounting e.g. EV/EBIT and P/FCF for starters. If P/E is similar to P/FCF then that is a very good sign. EPS can be manipulated but it is much harder to fake FCF PS.

All the best, Si

Just a small point, but how can dividend yield be manipulated? Surely the two operands used in the simple calculation (dividend per share and share price) are both undeniably factual and publicly visible making it very simple to verify. In fact, out of all the metrics mentioned, isn't it the only one you can be totally confident about?!

[SalvorHardin]

Simoan has kindly linked to a book that tries to demystify company accounts earlier in the thread, but unfortunately there doesn't seem to be a book available to 'Demystify business culture', so this is all a bit of a grey area for someone who might lack the ability to easily see through the 'culture' of a company (without using any hind-sight bias, of course...), so whilst your own results using whatever approach you use are clearly admirable enough Dod, it doesn't really help anyone if they themselves would also wish to learn the same soft-skills...

I would highly recommend Warren Buffett's letters to Berkshire Hathaway shareholders as an excellent guide to business analysis for investors. They've been described as better than an MBA by many people who've got MBAs.

The letters can be found on Berkshire Hathaway's website. An alternative source is Lawrence Cunningham's book "The Essays of Warren Buffett: Lessons for Corporate America", which summarises the letters.

http://www.berkshirehathaway.com

Terry Smith's "Accounting for Growth" is the book about how companies fiddle their accounts. A good example in ROCE calculations is to leave any goodwill paid for acquisitions out of the calculations, so as to increase the ROCE. This used to be popular with companies who had recently made an aquisition where there was a lot of goodwill.

[simoan]

Just a small point, but how can dividend yield be manipulated? Surely the two operands used in the simple calculation (dividend per share and share price) are both undeniably factual and publicly visible making it very simple to verify. In fact, out of all the metrics mentioned, isn't it the only one you can be totally confident about?!

I was really referring to P/E, where the E can be a number based on all kinds of adjustments made at a company's discretion. Adjustments are supposedly exceptional and one-off in nature and are made to show the underlying earnings of a company, but some companies make adjustments which falsely enhance earnings.

Whilst dividend yield can't be manipulated directly you can't tell from looking at it whether the dividend is covered by EPS (which in itself may be manipulated), or more importantly, covered by Free Cash Flow. If a company is using debt to fund a dividend, it is not going to last very long before it is cut. So the dividend yield on its own does not tell you much without understanding how it is being funded..

All the best, Si

[CryptoPlankton]

Just a small point, but how can dividend yield be manipulated? Surely the two operands used in the simple calculation (dividend per share and share price) are both undeniably factual and publicly visible making it very simple to verify. In fact, out of all the metrics mentioned, isn't it the only one you can be totally confident about?!

I was really referring to P/E, where the E can be a number based on all kinds of adjustments made at a company's discretion. Adjustments are supposedly exceptional and one-off in nature and are made to show the underlying earnings of a company, but some companies make adjustments which falsely enhance earnings.

Whilst dividend yield can't be manipulated directly you can't tell from looking at it whether the dividend is covered by EPS (which in itself may be manipulated), or more importantly, covered by Free Cash Flow. If a company is using debt to fund a dividend, it is not going to last very long before it is cut. So the dividend yield on its own does not tell you much without understanding how it is being funded..

All the best, Si

Well, you did actually refer to dividend yield as well, but I will take your later agreement as acknowledgment of my (admittedly minor) point...

[simoan]

Well, you did actually refer to dividend yield as well, but I will take your later agreement as acknowledgment of my (admittedly minor) point...

Well , I mentioned dividend yield but did not mean to imply it was open to manipulation, not in the way you interpreted. Here's what I wrote again:

"Everybody will have their own approach. For instance, I rarely look at P/E or dividend yield when deciding on the investment merits of a company, and prefer to use metrics that are less open to manipulation by creative accounting"

This is true. I rarely look at P/E and dividend yield and prefer to use other metrics. I can see how you could interpret this as me saying both the P/E and the dividend yield could be manipulated but that was not my intention. Let's not disrupt an interesting thread about investing by having some pedantic discussion about my poor use of English

All the best, Si

[Dod101]

I completely and wholeheartedly agree with reading Warren Buffet's letters to his shareholders, especially the earlier ones. That is all you need to know about investing really. That and experience and with that will inevitably come a few investing mistakes from which you will learn.

Dod

[TheMotorcycleBoy]

A good example in ROCE calculations is to leave any goodwill paid for acquisitions out of the calculations, so as to increase the ROCE. This used to be popular with companies who had recently made an aquisition where there was a lot of goodwill.

By that token, I'm thinking that me and Mel's current hobby horse of perusing several annual reports and working out ROCE figures ourselves is no way a bad thing.

I've just quickly done Burford Capitals and Advanced Medical Solutions earlier on. Hardly took any time....all the firms I've so far researched, fortunately have very accessible Annual report PDFs. I start by doing the most recent (2017), and use the asset side (TA - CL) and then I double check using the equity side to ensure that "capital employed" is the same in both cases, then finally I google for the 2017 ROCE for the firm online, the Telegraph being fairly forthcoming in that regard:

https://shares.telegraph.co.uk/fundamentals/?epic=AMS

I found some variation in how different firms present their figures, presuming depending on their accountant/FD's style, what the board tell the finance dept. to present. I found AMS somewhat sly, as their printed something called "Gross profit", which I mistook as EBIT/OpProfit, only to discover later on (after a cross check with the internet!!), that a couple of lines later they deduct "Administrative + Distribution costs" later on, and finally then I had an EBIT (which they described as "Profit from Operations". Anyway the crux being, that once I've double/triple checked the most recent reports, the remaining PDFs I'd downloaded for that firm, i.e. 2016,15,14 were a breeze.

[TheMotorcycleBoy]

I would highly recommend Warren Buffett's letters to Berkshire Hathaway shareholders as an excellent guide to business analysis for investors. They've been described as better than an MBA by many people who've got MBAs.

The letters can be found on Berkshire Hathaway's website. An alternative source is Lawrence Cunningham's book "The Essays of Warren Buffett: Lessons for Corporate America", which summarises the letters.

http://www.berkshirehathaway.com

More to read! Will take a quick look one of these days.
Matt

[simoan]

More to read! Will take a quick look one of these days.
Matt

Matt,

I agree that it is worth reading the Buffet letters for some great investment wisdom. However, as Dod said earlier, the main thing is to decide what you want to get from your investments and find an approach that works for your own personality to achieve those goals. Over the years I've read all kinds of books promoting various ways of making money from stock market investing but you really need to find what works for you and Mel, not anybody else.

Possibly the most important aspect of investing is psychological and so I would suggest reading more generally about the biases in-built into all of us and get to appreciate your own personal biases and how these may effect your own decision making. To that end I would recommend reading Kahneman & Tversky, Thaler et al. and more generally things like Taleb. These are the books I have found most useful for my investing, not any of the get rich quick books. And if you don't have time IMHO the best investment book you can ever read is James Montier's "Little Book of Behavioural Investing": https://www.amazon.co.uk/Little-Book-Be ... bc?ie=UTF8 And don't just read it once! I keep a copy by my bed and re-read sections on a fairly regular basis much to the annoyance of my other half, but it sounds like your other half may be more understanding

The only other investing book I would recommend is also a very short book and that is Lee Freeman-Shor's "The Art of Execution": https://www.amazon.co.uk/Art-Execution- ... eeman-shor It's all very well buying shares, that's the easy bit, but knowing when to sell and having the discipline to go through with it is probably the thing private investors struggle the most with. I know I do! This book is brilliant for explaining what works and what doesn't and breaking down various approaches into types of investor. FWIW I'm a combo of Hunter and Connoisseur although when I started out I was very much a Rabbit!

All the best, Si

[TheMotorcycleBoy]

Sounds like I need to spend more time reading, and less time looking at balance sheets!!

When it comes selling, and how to know when, yes that's hard, I think.

One of first stocks was focusrite (TUNE) we bought it in mid-March. Within 6-7 weeks it had risen by 19%. We decided that "that's too good to be true", so we sold it up. For the time being, that was quite a good move (we'll we think it was) as the stock has since been a bit less.

However, we do need a better approach long term.

We do have another book "The Naked Truth". Personally I find it a little silly, (Mel seems to approve of it, though), but I appreciate that it does have one or two gems of wisdom in it. But anyway the author, does refer to setting various sell-points (stop loss prices etc.) in his general trading businesses.

Matt

[simoan]

Sounds like I need to spend more time reading, and less time looking at balance sheets!!

Balance sheets are very important and being able to understand them will give you an edge particularly if you invest mainly in small caps as it seems you are doing. Personally, I don't bother looking at the balance sheet of FTSE 100 companies as they are incredibly difficult to follow (with the possible exception of Next and a few others) and let's face it, it's not a good use of time as they are analysed to death by the markets.

One of first stocks was focusrite (TUNE) we bought it in mid-March. Within 6-7 weeks it had risen by 19%. We decided that "that's too good to be true", so we sold it up. For the time being, that was quite a good move (we'll we think it was) as the stock has since been a bit less.

I own Focusrite too! I have sold and re-bought a couple of times on the way up from around £2 which in hindsight was a stupid thing to do but at the time it was the correct approach from a risk perspective.

FWIW I keep a journal of all my trades with comments as to why the trade was made at the time. I used to struggle with anchoring on a price, particularly of a sale, but no longer do so and I am happy to admit I made a mistake and buy back a share at a higher price, particularly if the company has issued news that it is trading well. It also saves a lot of effort buying into companies you are already familiar with. The trading journal can be quite painful to look at when you sell a good company too early, but that pain is all part of the learning process. I would highly recommend keeping a log of your trades. I use an Excel spreadsheet with automatic Yahoo price updates to make the pain worse by being able to see how much profit I lost (or gained!) by making the trade. You really need to make sure by trading a share you are adding value, and if not, you should stick to ETF index trackers.

However, we do need a better approach long term.

We do have another book "The Naked Truth". Personally I find it a little silly, (Mel seems to approve of it, though), but I appreciate that it does have one or two gems of wisdom in it. But anyway the author, does refer to setting various sell-points (stop loss prices etc.) in his general trading businesses.
Matt

I guess you mean The Naked Trader? I have never read his books as I know it is a particular method that would not work for my personality. In particular, I never use stop losses and I am not a trader.

All the best, Si

[OLTB]

The only other investing book I would recommend is also a very short book and that is Lee Freeman-Shor's "The Art of Execution": https://www.amazon.co.uk/Art-Execution- ... eeman-shor It's all very well buying shares, that's the easy bit, but knowing when to sell and having the discipline to go through with it is probably the thing private investors struggle the most with. I know I do! This book is brilliant for explaining what works and what doesn't and breaking down various approaches into types of investor. FWIW I'm a combo of Hunter and Connoisseur although when I started out I was very much a Rabbit!

Yes, yes and yes - read this book!

Cheers, OLTB.

[TheMotorcycleBoy]

...
We do have another book "The Naked Truth".

I guess you mean The Naked Trader? ...

Oh my! Now that's a typo and a half!

I guess involvement in forum chat, whilst at work isn't always such a good plan.

Yup, 'twas "The Naked Trader"....

[TheMotorcycleBoy]

Well, all I can say is the ROCE figure is certainly a very weird figure when applied to a firm such as Legal And General. We own some shares in L&G and were attracted to it, due to the Div. yields seeming to be quite good, and wanted to create a diverse portfolio, so a contribution from an Insurance/pension co. seemed like to a good idea.

Anyway, after trawling through reams of very tedious figures about various different divisions, operations, blah blah. I finally calculated a ROCE = 0.51%. This seemed some what pathetic but I double checked on

https://shares.telegraph.co.uk/fundamentals/?epic=LGEN

and ta-da! I wasn't that far off....

seems like some soft skills needed to access whether L&G is a good or bad buy!! Dod what do you reckon?

Matt and Mel

[Dod101]

L & G is one of those shares that I am very happy to hold which I have done since 1995. I am sure I have commented on it before (probably many times) but I have long since taken more than my original investment out in cash and still hold L & G shares valued at about 8 times my original investment. This has been a good share for me.

Over the years there has been a share split and at least a couple of rights issues but since 2002 since when there has been no further capital reconstruction, when the dividend was a total of 4.92p it is for 2017 15.35p with the final being paid in early June.

As for ROCE, life assurance and pensions companies have,more than usual, very opaque accounts. To get the ROCE you would need to differentiate between the capital belonging to shareholders and the capital belonging to the policyholders and those drawing a pension. Life companies need to hold huge reserves against another 2008 say and they do not belong to the shareholders until the last liability, pensioner or policyholder, has been discharged, a bit like the principle of running a zombie life insurer. I suspect that is why the ROCE looks so small.

But I am no expert.

HTH

Dod

[simoan]

Well, all I can say is the ROCE figure is certainly a very weird figure when applied to a firm such as Legal And General. We own some shares in L&G and were attracted to it, due to the Div. yields seeming to be quite good, and wanted to create a diverse portfolio, so a contribution from an Insurance/pension co. seemed like to a good idea.

Anyway, after trawling through reams of very tedious figures about various different divisions, operations, blah blah. I finally calculated a ROCE = 0.51%. This seemed some what pathetic but I double checked on

https://shares.telegraph.co.uk/fundamentals/?epic=LGEN

and ta-da! I wasn't that far off....

seems like some soft skills needed to access whether L&G is a good or bad buy!! Dod what do you reckon?

Matt and Mel

Matt & Mel,

As you have found ROCE does not apply to financial companies. It's fairly obvious why when you think about it... they don't have working capital (current assets and liabilities)in the same way a manufacturing company might. I would ignore the ROCE figure for Legal and General as it is pretty meaningless. Most people use Return On Equity (ROE) for measuring the profitability of financials instead.

EDIT: Also, it's worth pointing out then when you say the ROCE is pathetic, you should not be using ROCE to compare with other companies in different industries. I can almost guarantee the ROCE of Aviva, Prudential, Old Mutual etc. are just as pathetic! If you're going to use ROCE use it to spot trends for the same company or for comparison to companies in the same industry only.

All the best, Si

[Dod101]

Well I would beg to differ from the views of simoan. Financial companies of course employ capital, that might be only equity but most also employ a lot of borrowed capital as well, such as bonds. Just ask L & G if they employ capital (that is what ROCE means) Of course they do.

Dod

[simoan]

Well I would beg to differ from the views of simoan. Financial companies of course employ capital, that might be only equity but most also employ a lot of borrowed capital as well, such as bonds. Just ask L & G if they employ capital (that is what ROCE means) Of course they do.
Dod

For the avoidance of doubt, I said financial companies do not have working capital (a key component of the ROCE calculation), not that they don't deploy any capital. I have checked and all the major insurance companies have ROCE < 1%. It is not the best way of determining their profitability and calculating ROCE is a waste of time. I'm just trying to save Matt & Mel time reading through Insurance company reports looking for numbers. Use ROE or some other measure instead, maybe one that takes into account the amount of leverage they use.

All the best, Si