We calculate the enterprise yield as follows:

Enterprise Yield = EBITDA / TEV

where EBITDA = earnings before interest, taxes, depreciation, and amortization TEV = market
capitalization + total debt – excess cash + preferred stock + minority interests Excess cash = cash +
current assets – current liabilities

We use total enterprise value (TEV) in a number of price ratios in this chapter. We also examine
another variation of the enterprise yield, EBIT/TEV, which substitutes EBIT for EBITDA:

EBIT / TEV

where EBIT = earnings before interest and taxes

1. Cash flow
Accounts Receivable

If accounts receivable decreases from the previous years (you have to

compare by going back a few years), this means that more cash has
entered the company from customers paying off their credit accounts. If
accounts receivable increases, this means that the company has sold
more products that money received.

In AeroGrow’s latest filing 10-Q filing (see above), we see that the cash
related to accounts receivable decreased by $9.9 million compared to a
decrease of $3 million a year ago. In other words, AERO sold $9.9 million
worth of goods without being paid, compared to $3 million the prior year.
They are both bad numbers, but the latest increase is a whopping 330%!

This is a huge warning sign that management is desperately, in a

maniacal way, trying to get their products onto any available shelf. Far too
aggressive.

Inventory

Same for inventory, which they burned $5.7 million on. Rather than
managing it, they’ve multiplied it like cockroaches. They currently have
$8.5 million in finished goods which I assume is supposed to meet the
demand they were expecting, except they have announced an expected
slow down.

It would have been better to keep it as raw materials and streamline

assembly processes in order to meet demand. Raw materials could be
sold at commodity prices if it came down to it, but finished goods
collecting dust will only fetch 50% at best in a fire sale.

Good indicator that management is unrealistic with performance and does

not perform proper market research.

(If raw materials increase but finished goods decrease, it means the
company has a problem with efficiency, processes and ultimately meeting
demand.)
Accounts Payable

The third big warning sign is accounts payable. Since this is a positive
number, the cash hasn’t left yet, so it’s been added back to net income
because it is stated as a liability in the Balance Sheet.

This means that AERO has delayed the payment but will have to pay this
huge amount in another period. An increase of $7.7 million in payables
will surely require the company to look for further credit or dilute
shareholders in order to pay it down.

Cash From Operations

For a company to be healthy, the cash from operating activities should be

positive, but the quality of the cash is just as important.

The net income at the top of the Cash Flow Statement should preferably
be a high positive number and the adjustment differences should not be
huge. If this is the case, the majority of cash from net income should drop
to the Cash from Operations line.

We see AeroGrow went from a net income of $(2.4 million) to Cash Used
in Operations of $(9.2 million) in 6 months. This is $2 million more than
the previous year and considering the size of the company, this is a first
degree burn.

You can also see the company spending to purchase new equipment and
receiving $9 million from financing with over $10 million in debt from $0
one year ago. Not the quality we want to see. Unsuspecting investors may
only see the Cash at Beginning of Period of $1.6 million and Cash at End
of Period of $0.4 million and think they used up $1.2 million. But we can
see the true number is $9.2 million.

Not to mention a $8 million market cap with $10 million in debt and more
coming.. you do the math.
2. Income Statement
Cost of Goods Sold
When analyzing the income statement, we should always try to compare
each line with Revenues as a percentage. As numbers go from 6 figures
(millions in revenue) to 9 figures (billions in revenue), it’s easy to lose
track of the numbers. Below is a screenshot of how I have
my spreadsheet set up.

Straight away we see that Crocs COGS (Cost of Goods Sold) is 98.6% of
revenues in its latest quarter. Also keep an eye out for how COGS
increases in relation to sales over many quarters. If COGS increases
faster than sales, that is a red flag which must be looked into.

Margins
If we then move to the gross profit line we have to consider many things
regarding margins. Gross margins tell you a lot about a firm’s competitive
position. If a company can increase its gross margins, the company is
doing two things;

1. cutting production costs or

2. raising prices

Both are good signs and margins that can trend up is always a good thing
and will lead to an increase in future earnings.

Unfortunately, for Crocs, compared to a year ago, their margins have

jumped off a cliff from an impressive 60% to 1.4% in 3 months ended
September 30. This deterioration could mean that raw and production
costs are rising, as evidenced by the increase in COGS compared to
2007.

If production costs increase, the company has to proportionally increase

their prices, but do people really want to spend an extra $5 for an already
expensive fad shoe? On the other hand, if a rise in production cost is not
the cause, then the company must be cutting prices in order to maintain
market share and gain some revenues.

Operating margins and net margins also provide vital information about
the capabilities of the company. Gross margins could be superb but if
operating margins are low, any drop in gross margins could have a
material effect on the overall profit of the company. Huge drop in gross
margins lead to a loss in operations and subsequently, net margins.

An important note about margins is that we must identify the company

strategy before immediately jumping to conclusions. Crocs is an example
of a typical company banking on high returns with low inventory turnover
to make a profit. Costco, Wal-Mart and other super retailers have small
margins yet their inventory turnover is extremely high. The volume of
products sold is where the profits come from. So think strategy before
dismissing a company completely.

Selling, General and Administrative Expenses

For a company doing so poorly, SG&A for Crocs is far too high. High
SG&A for any company is a serious problem. This line is also where
companies expense the limos, private jets, boats etc used by executives.
For a company doing so poorly, as a shareholder you would expect the
CEO to take economy.

Companies should try to keep SG&A to a certain percentage of revenues.

This prevents future problems caused by hiring sprees and huge bonuses.
Costco has been able to keep their SG&A between 8.5-10% for the past
10 years. A clear indication of the quality of management.

Impairment Charges
A fancy way of saying “we made some bad decisions which will cost us
millions of dollars”. This is not a line in the Income Statement that we
want to see. Crocs is writing off $31.6m from goodwill in the 3rd quarter
which is essentially writing off $31.6m from equity. Another reason why a
company with high goodwill should be examined further.

Impairment charges is also another way to evaluate management.

The impairment charge also provides investors with a way to evaluate

corporate management and its decision-making track record. Companies
that have to write off billions of dollars due to impairment have not made
good investment decisions. Managements that bite the bullet and take an
honest all-encompassing charge should be viewed more favorably than
those who slowly bleed a company to death by deciding to take a series of
recurring impairment charges, thereby manipulating reality. – Investopedia

Other Income, Income tax, EPS, Shares

Outstanding
Footnotes should always be reference to determine exactly what Other
Income is. This is evermore true if the number is high.

Income tax and Earnings Per Share (EPS) is straightforward and doesn’t
require additional comments.

Shares outstanding should be monitored as well. Always use the diluted

number as it includes stock options. Crocs has been buying back its
shares from the previous year in an attempt to increase shareholder value
but that is a minor point compared to what has been discussed above.

Summary
 View numbers as percentages and compare over several quarters
and years
 COGS should never be higher than sales
 Margins reflect competitive position and company strategy
 SG&A and Impairment Charges determines the company’s
management quality

That is how to properly conduct an income statement analysis.

Formula: The Secret Sloan Ratio

Sloan Ratio = (Net Income – CFO – CFI) / Total Assets

CFO = Cash From Operations

CFI = Cash From Investments

If the Sloan Ratio is between -10% and 10%, the company is in the safe
zone and there is no funny business with accruals.

If the Sloan Ratio is less than between -25% and -10% on the negative
side, and between 10% and 25% on the positive side, this is a warning
stage of accrual build up.

If the Sloan Ratio is less than -25% or greater than 25%, and this ratio
is consistent over several quarters or even years, be careful. Earnings are
highly likely to be made up of accruals.

Formula: Balance Sheet and Cash Aggregate Accrual Ratio

Use this formula to calculate the balance sheet accrual ratio and cash flow
accrual ratio.

Next, subtract last period’s NOA from the current NOA figure to arrive at
Balance Sheet Aggregate Accruals.

The Balance Sheet Aggregate Accruals Ratio is determined by dividing

that number by the average accruals.

The procedure is similar when calculating Cash Flow Aggregate Accruals,

as shown below.

What to Watch Out For With Accruals

You now have the secret sauce to check accruals. Use it to watch out for
the following.
  A jump in earnings accompanied by a jump in the accruals ratio
should raise a red flag.
 A higher than industry-average growth rate with a higher than
industry-average accruals ratio.
 High balance sheet accruals indicate that the company has
expanded its asset base rapidly.
 High balance sheet accruals also have a higher ROE.
 Companies with high balance sheet accruals tend to have higher
sales growth than low balance sheet accrual companies.
 Companies with low balance sheet accruals tend to have below
average returns on equity. Analysts expect the company to lag.
 Balance sheet accrual can indicate whether capital is being used
properly. A company with high accruals can come from acquiring or
merging with companies which expands the asset base.
 Low balance sheet accrual companies tend to shrink their balance
sheet through spin offs, share repurchases or large write offs. In
these situations, it is usually removing bad performing assets or
returning money to shareholders which is always a good use of
capital.

The PROBM model is made up of the following components:

■ DSRI = days’ sales in receivables index. Measured as the ratio of days’

sales in receivables in year t to year t − 1. Large increases could indicate
attempts by management to infl ate revenues

■ GMI = gross margin index. Measured as the ratio of gross margin in

year t − 1 to gross margin in year t. Gross margin has deteriorated when
this index is above 1. All else being equal, a fi rm with poor prospects is
more likely to engage in manipulation.

■ AQI = asset quality index. Asset quality is measured as the ratio of

noncurrent assets other than plant, property and equipment to total
assets. AQI measures the proportion of total assets where future benefi ts
are more opaque and the assets are considered intangible. The measure
may indicate attempts at cost deferrals in the form of intangible assets on
the balance sheet.

■ SGI = sales growth index. Ratio of sales in year t to sales in year t − 1.

Sales growth does not indicate manipulation; however, high sales growth
does create certain expectations for management—many of which are
unsustainable. Managers who face decelerating fundamentals and who
currently manage high-expected-growth fi rms have high incentive to
manipulate earnings

. ■ DEPI = depreciation index. Measured as the ratio of the rate of

depreciation in year t – 1 to the corresponding rate in year t. DEPI greater
than 1 indicates that assets are being depreciated at a slower rate.
Managers may be adjusting depreciation methods to temporarily infl ate
earnings.

■ SGAI = sales, general and administrative expenses index. The ratio of

SGA expenses in year t relative to year t − 1. Firms with growing SGA
may indicate managers who are capturing fi rm value via higher salaries.
■ LVGI = leverage index. The ratio of total debt to total assets in year t
relative to year t − 1. An LVGI greater than 1 indicates an increase in
leverage, which may increase the probability that a fi rm will breach a debt
covenant. All else being equal, the probability of manipulation is higher in
the face of a potential covenant breach.

■ TATA = total accruals to total assets. Total accruals calculated as the

change in working capital accounts other than cash less depreciation.
High accruals indicate a higher likelihood of earnings manipulation.

The eight variables from PROBM are then weighted together according to
the following:

PROBM = −4.84 + 0.92 × DSRI + 0.528 × GMI + .404 × AQI + 0.892 ×

SGI + 0.115 × DEPI −0.172 × SGAI + 4.679 × TATA − 0.327 × LVGI
If M-Score is less than -2.22 - the company is unlikely to be a manipulator.
If M-Score is greater than -2.22 - the company is likely to be a manipulator.

The Piotroski score is broken down into profitability; leverage, liquidity, and source of
funds; and operating efficiency categories, as follows:

Profitability Criteria:

 Positive Net Income (1 point)

 Positive return on assets in the current year (1 point)
 Positive operating cash flow in the current year (1 point)
 Cash flow from operations being greater than net Income (quality of earnings)
(1 point)

Leverage, Liquidity and Source of Funds Criteria:

  Lower ratio of long term debt in the current period, compared to the previous
year (decreased leverage) (1 point)
 Higher current ratio this year compared to the previous year (more liquidity) (1
point)
 No new shares were issued in the last year (lack of dilution) (1 point).

Operating Efficiency Criteria:

 A higher gross margin compared to the previous year (1 point)

 A higher asset turnover ratio compared to the previous year (1 point)

If a company has a score of 8 or 9, it is considered a good value. If the score adds

up to between 0-2 points, the stock is considered weak. Piotroski's April 2000 paper
"Value Investing: The Use of Historical Financial Statement Information to Separate
Winners from Losers," demonstrated that the Piotroski score method would have
seen a 23% annual return between 1976 and 1996 if the expected winners were
bought and expected losers shorted. As a starting point, Piotroski suggestd investors
begin with a sample of the bottom 20% of the market in terms of price-to-book value.

Of course, with any investment system, looking at past results doesn't mean it will
work the same way in the future.

Scoring with the Piotrosky Method

As an example of the Piotrosky scoring method in action, note the following criteria
calculations for Foot Locker (FL) in 2016:

 Profitability:
o 2016 Net Income ($664,000,000) (Score:1 point)
o 2016 ROA (17%) (Score: 1 point)
o 2016 Net Operating Cash Flow ($816,000,000) (Score: 1 point)
o 2016 Cash Flow From Operations ($816,000,000) > Net Income
($664,000,000) (Score: 1 point)
 Leverage:
o 2016 long-term debt ($127,000,000) v. 2015 long-term debt
($129,000,000) (Score: 1 point)
o 2016 current ratio (4.30) v. 2015 current ratio (3.72) (Score: 1 point)
o No new shares issued in 2016 (Score: 1 point)
 Efficiency:
o 2016 Gross Margin (33.94%) v. 2015 Gross Margin (33.08%) (Score: 1
point)
o 2016 Asset Turnover Ratio (2.04) v. 2015 (2.02) (Score: 1 point)

Foot Locker's total Piotrosky score in 2016 was a full 9, making it an excellent value
proposition as of 1/28/17, according to the Piotrosky method.
Current Profi tability We use three variables to measure a stock’s current profi tability
and cash fl ow realization:

■ ROA and FCFTA are net income before extraordinary items and free cash fl ow,
respectively, divided by most recent total assets. If the stock’s ROA or FCFTA is
positive, we defi ne the variable FS_ROA or FS_FCFTA as one, and zero if
otherwise.

■ ACCRUAL is the stock’s current year’s net income before extraordinary items less
cash fl ow from operations, scaled by beginning of the year total assets. The variable
F_ ACCRUAL is marked one if FCFTA is greater than ROA, and zero if otherwise.

Our current profi tability variables are similar to Piotroski’s profi tability variables,
except that we replace the CFO variable with free cash fl ow divided by total assets
(FCFTA). We make this change to take into account the impact of capital
expenditures on the stocks’ cash fl ows. We also exclude the variables ΔROA and
ΔFCFTA from this category, and move each to our “recent operational
improvements” category because we believe it is a more intuitive category for these
variables.

Stability Like Piotroski, we assume that an increase in leverage, a deterioration in

liquidity, or the use of external fi nancing is a bad signal about fi nancial health. Our
stability signals measure changes in capital structure and the stock’s ability to meet
future debt service obligations:

■ ΔLEVER is the historical change in the ratio of total long-term debt to total assets.
FS_LEVER is one if the stock’s leverage ratio fell in the preceding year, and zero if
otherwise.

■ ΔLIQUID is defi ned as the year-over-year change in the ratio of current assets to
current liabilities. The variable FS_ΔLIQUID is one if the stock’s liquidity improved,
and zero if otherwise.

■ NEQISS is equity repurchases minus equity issuance, or net equity issuance.

FS_NEQISS is set to one if repurchases exceed equity issuance, and zero
otherwise.

Our stability category differs from Piotroski’s in one important way: We replace the
F_SCORE’s equity issuance variable, EQ_OFFER, with net equity issuance, or
NEQISS, which is defi ned as repurchases minus issuances. (We use the same
technique found in Boudoukh, Michaely, Richardson, and Roberts’s 2007 article, “On
the Importance of Measuring Payout

Yield: Implications for Asset Pricing.”6) We make this small, but important, change
because we believe Piotroski’s EQ_OFFER can be a misleading metric. For
example, many fi rms issue shares for a variety of reasons unrelated to fi nancial
health, including management or employee incentive programs. A company may
issue a small number of shares to compensate a CEO, but simultaneously initiate a
substantial repurchase program that dwarfs the number of shares issued to the
CEO. EQ_OFFER would penalize this stock because of the small equity issuance,
while NEQISS would consider the relative size of both the buyback and the issuance
and score accordingly. Each metric would be scored in the following way:
EQ_OFFER would be zero and have no effect on F_SCORE; NEQISS would
increase by one and increase FS_SCORE.

Recent Operational Improvements We introduce a new section for the FS_SCORE:

recent operational improvements. This category is roughly equivalent to the
F_SCORE’s “operating effi ciency” section, except that the focus in our FS_SCORE
is on improvements. We include in our recent operational improvements category the
following:

■ ΔROA is the current year’s ROA less the prior year’s ROA. If ΔROA is greater
than zero, the variable F_ΔROA is marked one, and zero otherwise.

■ ΔFCFTA is the current year’s FCFTA less the prior year’s FCFTA. If ΔFCFTA is
greater than zero, the variable FS_ΔFCFTA is marked one, and zero otherwise.

■ ΔMARGIN is the stock’s current gross margin ratio (gross margin divided by total
sales) less the prior year’s gross margin ratio. The indicator variable FS_ΔMARGIN
equals one if ΔMARGIN is positive, and zero if otherwise.

■ ΔTURN is the stock’s current year asset turnover ratio (total sales scaled by
beginning of the year total assets) less the prior year’s asset turnover ratio. The
indicator variable FS_ΔTURN equals one if ΔTURN is positive, and zero if otherwise.

We examine recent operational improvements to ascertain whether the business has

operational momentum. We don’t want to buy a seemingly cheap stock that gets
increasingly expensive relative to its fundamentals because the business
deteriorates. For example, a stock with $100 million in EBIT trading for $300 million
is trading on multiple of 3. If operations deteriorate to the extent that next year’s EBIT
is only $50 million, the “bargain” multiple of 3 becomes a more expensive multiple of
6. If this halving of EBIT continues, we will be left holding a very expensive stock
after a few years.

FS_SCORE Formula and Interpretation Our FS_SCORE has ten metrics across the three categories of
profi tability, stability, and recent operational improvements. The fi nal score is from 0 to 10, where
10 is a perfect score, and 0 is the worst score possible. The FS_SCORE formula is as follows:

FS_SCORE = Sum(FS_ROA, FS_FCFTA, FS_ACCRUAL, FS_LEVER, FS_LIQUID, FS_NEQISS, FS_ΔROA,

FS_ΔFCFTA, FS_ΔMARGIN, FS_ΔTURN