The Grigsby Place Acquisition Analysis by Terry Asante

Attached below is an acquisition analysis i created for a 20 unit apartment complex located in the Knox/Henderson submarket of Dallas, Texas.

The Grigsby Apartments Acquisition Analysis by Terry Asante

Asante Investments LLC Multi-Family Acquisition Screening Criteria

Asante Investments LLC Multi-Family Acquisition Screening Criteria

Investment Parameters

• Purchase Price – $350,000 ($23,333/unit)- $500,000 ($33,333/unit)
• Acquisition Cap Rate of 7% – 10%
• Minimum Leveraged Cash on Cash Return 8%-11%
• Below market rents of 20-25% with minimum effective rents of $700.00-$720.00
• Minimum economic occupancy of 80%
• Minimum Operating Expense Ratio of 35% or Net Operating Ratio (Net of Reserves) of 65%
• Minimum Monthly Trailing Break-Even Ratio of 55-65%
• Positive Trailing Monthly Net Cash Flow (net of capital reserves) for the past three years
• A monthly debt service coverage ratio (net operating income/debt service) greater than 1.20x for the T-12 period

Debt Pricing Parameters

• All-In Interest Rate of 5.75% – 6.75%
• Loan to Value of 75% – 80%
• Unencumbered property with no liens or deed restrictions (The Property should possess a clean and marketable title)

Apartment Profile

• 65% of the total unit mix should be studio and one-bedroom
• A minimum of 20 units
• Class B, B- or, C+ apartment complex in close proximity to Class “A” environments
• Value-add property with below market rents in need of a light exterior and interior renovation
• No flat roofs, gas air conditioners, asbestos, and insulation problems
• No major structural problems with the building such as foundation, roof, contamination or electrical wiring problems
• The ability to convert excess or rentable space to fitness center and/or laundry mat
• High traffic count near the property

Tenant Profile

• Blue collar tenant profile as well as young family households with the opportunity to integrate white-collar professionals in the tenant mix
• Close proximity to tenants who hold professional jobs in the medical, financial/investment, education, and technology sectors

Demographic Profile

• Close proximity to major shopping, eateries, exceptional educational institutions, and public transportation/interstate highways
• Crime-Free Area
• $50,000 within a one mile radius, $65,000 within a three-mile radius, and $65,000 within a five-mile radius
• Close proximity to professional, medical, and financial/investment services jobs from the property
• Population, income, and economic growth in the submarket or nearby “bedroom” communities is a must

Please contact me at Terryasante27@yahoo.com

Creating an Apartment Feasibility Model for Asante @ Park Cities Product Samples

To learn more about Creating an Apartment Feasibility Model for Asante @ Park Cities product offerings, please download the sample products below:

Asante @ Park Cities Investment Manual Sample

Creating An Apartment Feasibility Model for Asante @ Park Cities Excel Model with waterfall schedule (no formulas)

Creating a Apartment Feasibility Model for Asante @ Park Cities User Guide

Creating an Apartment Feasibility Model for Asante @ Park Cities by Terry Asante

Hello and welcome to Creating an Apartment Feasibility Model for Asante @ Park Cities by Terry Asante. This video will give you a quick overview of the main components in the model. Thank you for watching.

Creating An Apartment Feasibility Model for Asante @ Park Cities Excel Model (no formuals)

Creating an Apartment Feasibility Model for Asante @ Park Cities

Taking a case study approach, the author, Terry Asante, walks you through the process of creating an apartment development feasibility model for Asante @ Park Cities, a proposed development of a 53-unit apartment complex located in the Oak Lawn/Park Cities submarket of Dallas, Texas. Domestic and international real estate investors, brokers, analyst and asset managers at real estate investment firms, investment banks, and commercial banks will find the analysis and model beneficial when considering an apartment development project. After completing the manual and model, the user will know how to do the following:

• Determine the unleveraged, leveraged before-tax, and leveraged after-tax, internal rate of return, net present value, and equity multiple based on any disposition year during the holding period
• Integrate “INDEX”, “MATCH”, and Data Validation to determine disposition value in any year during the holding period
• Toggle quickly between upside, downside, and base case cash flows by using the CHOOSE function
• Use the “IF”, “MIN” and “ SUM” Functions to properly offset the taxable income by the net operating losses (“NOL’s”) generated by depreciation and interest expense
• Combine the “SUM”, “OFFSET” and “MATCH” Functions to deduct the proper amount of reserves based on the disposition year
• Prepare market feasibility analysis for the Oak Lawn/Park Cities submarket of Dallas, Texas to understand the trends in rents, occupancy, and absorption
• Prepare a sources and uses schedule as well as a transaction summary for an Investment Memorandum
• Construct a sensitivity table to show how the disposition value is impacted when the cap rate and NOI assumptions simultaneously change
• Enhanced marketability in the job market by acquiring real estate financial analysis and Microsoft excel skills

New Posts Coming Soon!

Hotel Market Analysis

This was a hotel analysis i conducted a year ago for my boss, Mr. Tariq, before hired as a credit analyst. Analysts, investors, hoteliers, and the like will find this analysis beneficial to understand some of competitive dynamics of the hotel industry. I utilized the concepts of Strategic Analysis and Action (7th edition) by Mary M. Crossan, Joseph N. Fry, J. Peter Killing and Michael J. Rouse to approach the analysis in a systematic manner. Also InterContinental Hotels Group (IHG) was used as the company of focus to understand how and why IHG made certain decisions to improve its profitability by understanding the strategic analysis approach.

Hotel Market Analysis

Creating a Financial Model for McDonald’s Corporation

• Creating a valuation technology that will allow us to estimate McDonald’s enterprise value (“the value of the entire business including debt lenders and other obligations”) of McDonald’s corporation i/a/o $112,756,491,893 and intrinsic value (the actual value of McDonald’s stock).
• Predicting the financial and economic performance of McDonalds by creating pro-forma financial models that allow us estimate the free cash flows (“the cash flow available to all security holders in the firm such as debt, equity, and convertible securities before any financing adjustment’s’’).
• Analyzing and researching McDonald’s corporate environment to gain a better understanding ofthe industry dynamics
• Synthesizing McDonald’s operations by analyzing their core activities such as marketing, production, supply chain management, and research and development.
• Parameterizing the historical financial statements of McDonald’s corporation which will allow us to make an informed prediction of McDonald’s future financial performance.
• Understanding why earnings (Revenues-Expenses=Profit) are important to McDonald’s equity holders.

For learning effectiveness, please download the excel model alongside with McDonald’s annual report and financial modeling formulas. I have also created a power point which entails the output of the valuation model alongside with the financial modeling formulas. If you have any questions regarding the model, please feel free to email me at AsanteTerry34@gmail.com. If you are satisfied with this product, please leave reviews at http://www.linkedin.com/pub/terry-asante/28/124/27b or   https://eco27.wordpress.com/ . Furthermore, if you know anyone desiring to learn finance, accounting and stock valuation please forward them this guide.

Thank you,
Mcdonald’s Corporation Valuation Guide

McDonald’s Corporation Valuation PPT

Mcdonald’s Corporation Valuation Excel Model

Financial Model Formulas

New Posts Coming Soon!

Key Financial Metrics of a Good Business

“Buy companies with strong histories of profitability and with a dominant business franchise”- Warren Buffet. If you take anything away from this blog post, focus your energy and time on companies who have ability to remain profitable and generate sustainable  cash flows for many years with little signs of stagnant growth. Investing is about buying great companies with durable competitive advantages at a fair or undervalued price with great long-term prospects run by competent and honest and  managers . This investment philosophy is what Warren Buffet and Charlie Munger have created to guide their investment philosophy. Is investing about buying companies with: low beta’s, hot new products and services, a sexy name, companies with unpredictable earnings, and a  business model that can be easily duplicated? The answer is no. Incorporate these financial metrics when analyzing a business.

Sales

Companies who are able to grow their sales year over year and at a greater rate than the industry average are more attractive than companies with stagnant sales growth. Phillip fisher, author of Common Stocks and Uncommon Profits and one of the greatest investors of all-time sought out companies with strong sales ability . Phillip first two points of his scuttlebutt approach was focused on the company ability to generate sales successfully. Point 1, states “does the company have products or services with sufficient market potential to make possible sizable increases in sales for at least 10 years”. You will need to have a full understanding of the company products, depth of their product line, and strength of their product portfolio ; coupled with the analysis of market potential, and existing and potential . For instance, companies such as Nike and Coca-Cola usually experience a strong sales growth no matter the economic cycle . Businesses with strong and growing demand coupled with a large market size are more attractive than companies who products are in the maturity and declining stage in the product life cycle. Preferably, you should look at sales over a time span of at least 8 years. Questions you should ask yourself as you analyze sales are:

• What is the year over year sales growth?
• What is the same store sales growth?
• Where is sales growth coming from (growing markets with consumers with strong purchasing power or markets that are maturing due to market saturation)?
• Is the sales growth sustainable (what are the potential substitutes in the market)?
• Is sales driven by increased pricing(more attractive becuase the company’s cost does not increase), price cutting (volume gains) acquisitions(more exposure into markets) or new products or services (market growth)?

In addition, point 2 of Phillip Fisher stock picking strategy, regarding sales,  is management determination to further increase its sales potential once currently attractive product lines have been currently exploited. Although, the company may have been wonderful at growing sales in the past, it may not able to generate sales in the future due to intense competition, and efficient and cheaper substitutes. To ensure you’re not stuck with a one hit wonder, find companies with great management and strong competitive advantages also know as barriers to entry. Barriers to entry for a company could be  intellectual property (patents), franchises with strong brand names, high capital requirements, strong distribution network to reach customers anytime and anywhere at a low cost due to their superior technology. These advantages insulate companies from intense competition and a intergral  force of the next financial characteristic of a great company.

Earnings Before Interest and Taxes (EBIT)

Before I go into detail on the definition of EBIT, we must understand the importance to the business owner. The value of a business is the present value of the expected free cash flows( the cash flow the business throws off to its capital providers) discounted at its minimum required rate of return(Weighted average cost of capital) on the stream of riskiness of the cash flow. Free cash flow equal= Earnings Before Interest and Taxes (EBIT)(1-Tax rate )- Fixed capital expenditures- Working capital requirements. EBIT as defined by Wall Street self-Instructor and CFA holder, Hamilton Lin, is the core, sustainable recurring profitability from core operations to the entire company before the effects of capital structure and leverage or debt”. Earnings before interest and taxes equal operating revenues minus operating expenses plus non-operating income. Non-operating income is the income not generated by the business core operations such as “dividend income,profits (and losses) from investments, gains (or losses) incurred due to foreign exchange,asset write-downs and other non-operating revenues and expenses.” We have to exclude the gains and losses because the income generated  from this event does not occur daily or frequent and not part of the company’s core operations. Companies who are able to able to grow their profits from their core operations which is measured by EBIT at an increasing rate are attractive business and should be researched further. Likewise, look over a time span of at least of a eight of years. Preferably, there should be an increase year over year. Also you must ask yourself what are the economic drivers (income, lifestyle ,age, consumer preference technological advances, seasonal factors, prices of substitutes, new products and services) of earnings of before interest and taxes.

Earnings Sustainability

Next, great financial characteristics of a wonderful company is their earning power or earnings growth. You cannot get ahead of the investment without truly understanding earnings growth and what creates it . Why is important to identify companies with sustainable earnings, again we must refer back the value of the business. As noted earlier the value of a business depends on the free cash flows generated by the assets, the expected growth of the free cash flows and the riskiness of the cash flows(as indicated by the minimum required capital providers expect on the stream of the cash flows. Free cash flow can also be defined as earnings available to common shareholders +Net noncash charges (depreciation and amortization)+ Interest expense (1-tax rate ) – Investment in fixed capital – Investment in working capital. What drives the earnings must drive the free cash flow which is the cash available to capital providers. If you observe the top companies such as Nike, Fed Ex, Apple, ISRG, Starbucks, Cat thing they have in common is the ability to grow their earnings consistently for a reputable time span . Why is this important? As an equity holder in the business you have a claim on the company future earnings and cash flow. If you identify companies with consistent earning power your claim become larger thus increasing your wealth. The factors that determines a company expected growth and earning power depend on “their competitive advantage period, assets in place , profit margins, management, barriers to entry, industry and competitive structure and new businesses and products and technology.

Earnings Quality

Aswath Damodaran, Author of Investment Valuation states ” all earnings growth is not equal. Earnings growth created by changes in accounting policy or acquisitions is inherently less reliable than growth created by rich increasing units sold, and should be weighted less in forecasting future growth.” In addition, you should analyze the company sustainable, recurring, permanent earnings. As Lawrence Revsine, Daniel Collins, Bruce Johnson and Fred Mittelstaedt indicates in Financial Reporting and Analysis validates

1. earnings are considered to be high quality when they are sustainable.

a. Sustainable earnings are generated from repeat customers, or from a high quality product that enjoys steady customer demand based on brand name identity, etc.

b. Unsustainable earnings derive from gains and losses from debt retirement, write-­offs of assets from corporate restructuring and plant closings, or reduction in discretionary expenditures for advertising and research and development, etc

One should eliminate one time sales and gains from the selling of assets and eliminate restructuring and asset impairments to find the true income generated from operations(unless non-recurring items occur frequently).” If a company has a gain on their income statement subtract it out from net income and  if a company has a loss on the their income statement add it back to net income. Likewise, if the company has a restructuring charge ( which are events and transactions that are unusual in nature and infrequent in occurrence) you should add it back to net income. We are simply trying to identify earnings available to common shareholders.

EPS

Furthermore, identify companies who are able to increase their earnings per share year over year and eliminate companies who earnings per share are not increasing or unpredictable. You may wonder why I am putting a heavy emphasis on the earnings ability of the company but the masters of investing view this figure as essential. In One Up One Wall street, Peter Lynch states, regarding what makes company valuable, ” there are many theories, but to me, it always come down to earnings and assets. Especially earnings.” In The Essays of Warren Buffett: Lessons of corporate America he states ” Our long-term economic goal (subject to some qualifications mentioned later) is to maximize the cash Berkshire’s average annual rate of gain intrinsic business value on a per share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress. There is a strong relationship between a company share price and earnings per share. Company who are able to grow their earnings per share at an increasing rate usually are usually  trading at high stock prices. Again, to assess the validity and growth of the EPS remove nonrecurring(unless they keep recurring as part of their business operations) items, and study the economic drivers of the company. Where did earnings per share growth come from (efficency, price increases, market growth, increased volume, new products and services, stock buyback(reducing the number of shares outstanding).

Sustainable Positive Cash Flow

You have identified a company that is growing earnings but earnings don’t  pay the shareholders,buy capital expenditures,pay operating expenses,and pay down long term debt-cash does. Make sure you when analyzing a business that earnings ,operating and free cash flow(cash flow available for distrubution to the owners of the company) are not diverging. For instance Green Mountain Coffee Roasters Specialty Coffee were growing their sales, earnings and EPS. The 3-year CAGR of sales, earnings and EPS for 2008-2011 was 74.34%,107.60%,89.23 respectively. Although earnings have increased steadily from 2007-2011, free cash from operations during the same period has been erratic and negative from 2008 to 2011. By defnition Free cash flow operations = Net Income +Depreciation + Interest expense (1-tax rate) -Fixed capital – working capital. If earnings and free cash flow are diverging beware.

Assets

To become a successful investor you not only have to buy companies that are able to increase their sales, EBIT, EPS , earnings, generate high returns on equity and return on invested capital relative to their industry and competitors, they must have superior assets in place to continue to remain profitable far in the future. Investopedia defines an asset such as “Assets are bought to increase the value of a firm or benefit the firm’s operations. You can think of an asset as something that generate cash flow regardless of whether it’s a company’s manufacturing equipment or an individual’s rental equipment. Although, many investors flock to the income statement, to see if the company is profitable, K.R Subramanyam, KPMG Foundation Professor of Accounting, and Associate Dean Marshall PhD Program states in his book Financial Statement Analysis, regarding the accounting equation (A=L+OE)

The left-hand side of this equation relates to the resources controlled by a company, or assets. These resources are investments that are expected to generate future earnings through operating activities.

What are a company assets? A company intangible and tangible resources that help the company  generate cash flow. For instance, Goldman Sachs competitive  advantage resides in its employees (human capital). Goldman Sachs is able to attract the brightest minds to create the best financial solutions for its clients. Clients are willing to pay top fees for Goldman services because the cost of a failed merger or abysmal  due diligence can cost millions of dollars. Access to a smart applicant pool, Goldman can work more efficiently(thus charging higher fees) than smaller investments banks who don’t have the resources to attract the best Job applicants. Likewise, a company tangible asset can be its product itself. Phillip Morris produces the largest selling brand of cigarettes in the world- Phillip Morris. The quality of the cigarette depends on high and satisfaction. Companies who are able to deliver these value propositions consistently in the marketplace are more valuable than companies whose products fail to resonate.

Stephen H. Penman, professor in the Graduate School of Business at Columbia University advises to distinguish a company operating assets from its financial assets to understand how the company makes its money from operations . Operating assets assist the company in the cash flow generation process when selling goods and services. The reformulated balance sheet helps distinguish the operating assets from financial assets. Generally a company’s. Financial assets are usually cash and cash equivalents, short-term investments, short-term notes receivable, and long term debt investments; but financial assets will be considered operating assets for a bank or any other financial institution. Why? because banks and financial institutions make money by lending money (the interest rate). Operating assets for an organization whose business models don’t resemble a bank or financial institution consist of long-term assets, intangible assets, operating working capital assets (accounts receivable, inventory, prepaid expenses).

Assets as a competitive advantage

When looking to buy or invest in a company apply the Wharton’s  sustainable competitive advantage criteria to the company’s assets which determines the success or failure of any company.

1   It is valuable-

An asset is valuable when produces a substantial amount of cash flow relative to the cost of maintain the asset (capital expenditures, interest and principal payments and short term debt) and there is intense demand for it ( Panera Bread unique bread and sandwiches)  increases efficiency(Caterpillar heavy duty construction equipment) and is reusable(people have to keep buying it-Gillette and Coke).

2. It is durable-

Blockbuster was once a leader in movie-rental, however once Netflix came along it deteriorated Blockbuster business model. Customers could rent movies at a lower cost because Net-Flix cost was lower and customers didn’t(more convenient and faster service) have to drive to miles to buy or rent a DVD or a movie. In addition, for a one time low flat fee , customers could watch a wide selection of movies. As stated in Wharton on Dynamic Competitive Strategy an asset “is durable and not vulnerable to rapid depreciation or obsolesce because of technological change, shifts in customer requirements, or the depletion of nonrenewable assets.” Another way to look at how durable an asset is by looking at its potential substitutes. If an asset has the potential to be substituted by a cheaper and/or  more efficient product that meet consumer needs the asset is not durable.

3. There is casual ambiguity-

There are many restaurants that serve outstanding burgers, but no restaurants are more successful than serving burgers than McDonalds. With low cost operations wide market share, and with a brand that everyone can trust, McDonalds can expand its operations with little invested capital because it generates a substantial amount of cash flow from operations. Jack-in Box has implemented the any size drink for $1 and Burger king alongside with Jack box have a dollar menu to cater to the value, cost conscious consumer. However, no  restaurant can match McDonalds cash generating ability because assets (financial capital, intangible assets, production technology-McDonalds high profit margins) are unique and integrated which leads to the next point.

4. The competitors cannot duplicate the assets-

Intuitive surgical is a company that created the da vinci surgical system which uses robotic  as oppose to open surgery to assist  surgeons during surgery. As stated in the Intuitive Surgical annual report ” The da Vinci Surgical System is designed to provide its operating surgeon with intuitive control, range of motion, fine tissue manipulation capability and 3-D, High-Definition (HD) vision while simultaneously allowing them to work through the small ports of MIS(minimal invasive surgery)”. The benefits of the da Vinci system are shorter recovery times, fewer complications, reduced hospitalization costs, less pain, faster recovery and return to normal activities. Nobody in Intuitive Surgical industry have proprietary know-how(proprietary knowledge) to be able create a similar robotic system (this gives monopoly power) delivering a unique value proposition.

Having an asset that cannot be duplicated is not enough to give a company a sustainable competitive advantage it has to be valuable indicated by the number of users adopting and the operating results (cash flow generation).With a sluggish US economy in 2011, approximately 360,000 surgical procedures were performed with the da Vinci Surgical System, up approximately 29% compared to 2010(adoption mostly occurring in overseas). Recurring revenue increased 30% to 979.5 million during the year ended December 2011 and operating income increased 25% to $694.8 million during the year ended December 2011. The da vinvi system is has been  so profitable that it does not need any long term debt to finance this asset.

5.The early movers are able to defer efforts at duplication with credible threats of retaliation.

Wal-Mart, the largest retail chain in the world builds up excess  capacity in inventory to price match or meet consumer demand at anytime and anywhere. This allows them to beat the mom and pop store because it would be too costly to carry every item and assortment. Wal-mart has the financial capital and size to react to any retailer  strategic move operating in the same relevant market. Likewise avoid investing in any company whose price is there only value proposition unless they have a great brand name, distribution power, and  bargaining power of suppliers. Price is not a competitive advantage because competitors can retaliate quickly by slashing prices(lower margins and cash flow) to entice consumers away from other competitors.

Profit margins

The calculation of profit margins are relatively simple but the intuition is what counts when analyzing a company current and future operating performance. Companies can achieve higher margins by raising prices (pricing power) or lower cost (scale and distribution power). Lets apply the analysis of margins to Anheuser-Busch InBev (BUD), the world largest brewing company by size and volume, manages a product portfolio of   over 200 brands of beer and services over 120 countries.

gross margin

Bud 5yaer average  gross margin of 56.2% has been higher than the brewer beverages industry, which is 53.1%. Bud has been able to retain more cents out every dollar gross margin than the industry because of the superior product mix, brand strength understanding of consumer preference, and efficiency of purchasing raw materials and supplies.  With over 200 brands of beer Each beer brand is  marketed different based on the demographics of the geographic region. For example in Bud annual report “a global brand Stella Artois generally targets the premium category across the globe, while a local brand likeport targets the value category in Canada”.  Bud has been primarily focused on  selling core and premium beer brands rather value branded beers because although value beer drives sales it does not drive margin growth and profits. Furthermore, in Bud in their Annual report “In a rapidly changing marketplace we seek to continue to focus on our customer needs”. Companies who are able to create a product specific  to a certain market will always (keeping all thing constant) have a higher margins than company who makes a product for a masses. Finally, by being the largest Brewer in the world( because of economies of scale, “the cost advantages that a business can exploit by expanding their scale of production”), Bud is able to attain their raw materials and packaging materials at lower cost than smaller competitors.

operating margin

Operating margins not only includes the components of gross margin but also includes “advertising, selling (sales staff, sales offices, sales materials, and other items directly related to the selling process),distribution, administration, research and development, royalties, and any other expenses not directly related to the cost of producing and selling a particular product.”BUD 5 year average  operating margin of 31.6% has been greater higher than brewer -beverages industry of 29.1%. Again, by being the largest brewer in the industry, Bud is able to advantage of marketing economies of scale. Marketing economies of scale according to tutor2u, a leading publisher of e-learning resources, is when “a large firm can spread its advertising and marketing budget over a large output and it can purchase its inputs in bulk at discounted prices if it has sufficient negotiation power in the market.”Servicing over 120 countries in 6 geographic regions with 137 production plants worldwide allows Bud to distribute their product efficiently and quickly  near wholesalers and/or retailers.

Likewise, Bud size operating margins are greater than the industry because of technical economies of scale. Technical economies of scales is when businesses with great size and financial capital can invest in expensive or specialized technology further making them more efficient. Bud has implemented Voyage Plant optimization which “aims to bring greater efficiency and standardization to our brewing operations and to generate cost savings, while at the same time improving quality, safety and the environment”. When firms indicate in this  their annual report systems or technique that improved efficiency; analyze the operating margins since the program conception to confirm its validity .

Net Margin

Net margin is simply how much of every dollar generated by sales did the company retain in Net Income. Net Margin not only includes the components of gross and operating margins but it’s also includes interest, tax, non-recurring and other income items. Bud net margin of 18.1% in 2011 was below the industry average of 19.1%. For everyone dollar generated in sales, Bud generated 18.1 cents in profits Although some investors may see this as a sign of weakness, skilled investors would take into account BUD market dominance and cash flow generating ability. Bud has taken out long term debt to expand its operations into more markets and to acquire other beer companies to accelerate growth. This has a  negative on Bud net margins in two ways. First, long-term debt to fund growth opportunities translates into increased interest expenses. Secondly,  Bud being the largest brewer in the industry, will pay a larger amount of taxes, even if they have a lower tax rate than their smaller competitors

Finally, Bud net margins give its business strategy is impressive. Bud is able to achieve a differentiation strategy(greater pricing power) by serving the premium and core brand markets  and have a cost advantage of over smaller firms due to its economies of scales or cost advantages.

Return On Assets= Net Income/ Sales or [Net Income/Sales]*[Total Assets/Total Sales]

To measure the efficiency of a  company assets in generating profits assess the return on assets formula.The return on assets can also be decomposed by multiplying the net margin by its asset turnover.By decomposing the return on assets formula, it gives us a deeper understanding of the profitability and efficiency of a company assets. Lets apply the decomposed formula to Bud

Net margin=Net income/sales

Net margin takes into account a company: brand loyalty, pricing power ,market position, the strength of substitutes in the market, cost structure(variable and fixed cost),extraordinary items , and gains and sales on equipment. For every $1.00 of sales in 2011, Bud generated .14995134=(5855/39046)cents in profits; an increase from 11 cents in 2010.

Asset turnover= Total sales/Total assets

The asset turnover measures the efficiency of a company assets in generating sales. Bud total assets decreased from 2010 to 2011,shrinking the denominator. With an asset turnover of .34939154=(39046/112427) in 2011, Bud generated .34 in sales for every $1.00 employed in assets. Although Bud asset turnover is low, it doesn’t seem to have a bearing on its return on assets because of their scale advantage and its ability to create beer products tailored to a specific target market, thus attracting higher margins.Multiplying the asset turnover by net margin, Bud return of assets of 5.239173% =(.14995134*.34939154)*100.For every $1.00 in assets, Bud generated .05239173 cents in net income.

Return on Equity= [Net Income/Sales]* [Total Sales/Total Assets] *[Total Assets/Shareholder’s Equity]

The return on equity tells us the rate of return the company generated for the stockholders investment. The equation above is also called the DuPont Identity. Decomposing the DuPont, we can see the drivers of return on equity .The DuPont captures the components of return on assets and its equity multiplier[Total Assets/Shareholders] to explain high a company finances its assets. In 2011,Bud equity multiplier was 2.98=($117,498.28/$37,492).

A company with a high equity multiplier, keeping all thing constant, will have a higher ROE, than a company with lower equity multiplier. This happens for two reasons company.1) debt is tax deductible. 2) Leverage. If a company can earn a higher rate of return than the cost of debt, shareholder wealth will increase. It’s important to not to take the ROE ratio at face value, take the extra time to calculate the ROE using the DuPont identify. Multiplying the  return on assets by the equity multiplier, Bud return on equity for 2011 was 15.61% =(5.239173%)(2.98). For every $1.00 invested in equity, Bud generated .1561 cents in net income.

Return On Invested CAPITAL-= EBIT (1-Tax rate)/ Debt +Equity  -Cash

Superior to the return on equity , the return on invested capital calculates the return not only to shareholders but to debt holders. Companies with high returns on invested capital are attractive businesses the assets are creating cash flow. For instance recall the accounting equation, assets =Liabilities + Owners equity. Debt and equity holders in invest in assets to generate cash flow. Cash generated from the core business  is depicted in the numerator (earnings before interest and taxes)(1-tax rate).The more cash the assets generate with respect to the amount invested capital the better. Bud after tax operating income 10283= 12681.06(1-.1891) and their invested capital is $106,331=$111,754.28-$5423 .Dividing the after operating income by the invested capital, Bud return on invested capital for 2011 is 9.67%=($10,283/$106,331).

It is standard practice to compare the return on invested capital to the cost of capital. The cost of capital is the minimum rate of return(   also called hurdle rate) that a company must earn  to attract capital from investors. The cost of capital can be calculated by using the capital asset pricing model (CAPM= Rf+Beta(Rm-Rf)) or calculated from a firm financial statements. If the return on invested capital is greater than required rate of return investors expect to earn on their investment, the company is creating value, if it is less than cost of capital, existing and future investors will look elsewhere.

Liquidity and Solvency and analysis

Finally analyze the company liquidity and solvency position to make sure the company has the financial resources to satisfy all short and long term obligations and interest payments (if the company has long term debt on the balance sheet). Although you’ve identified a profitable company, it may have a hard time paying its bills because its capital tied in to fixed assets and/or inventory which is far less liquid. To evaluate a company  ability to satisfy  short term obligations or current liabilities analyze the quick and current ratio. Secondly , analyze the company coverage ratio to ensure the company is able to meet all interest payments. Failure to meet interest payments or other contractual obligations such as lease payments can force a company into bankruptcy. After assessing the coverage ratios, evaluate how the company is financing its assets, using the debt-to equity and debt to assets. Lets apply the analysis to Bud 2011 and 2010 financial statements.

Current ratio=current assets/current liabilities

Bud current ratio decreased from .80 in 2010 to .63 in 2011. At an instant, a current ratio below 1 may signal liquidity problems for Bud, but it is not necessary to draw conclusions before understanding the causes for such a low ratio. One of the main causes was due to the increase in trade payables to pay for inventory. In Bud annual report it states :

                Net cash from operating activities in 2011 increased by USD 2,581 million, or 26.1%, from USD 9,905  million in 2010 to USD 12,486 million in 2011. The increase mainly results from higher profits generated in 2011 and strong contribution from changes in working capital. The working capital improvements reflected primarily the results of ongoing trade payables initiatives. In addition, there was an increase in trade payables related to higher capital expenditures, these payables having, on average, longer payment terms.

The decline in the current ratio was the result of trying to meet increase in consumer demand. Bud needed to buy inventory on credit from suppliers or else pay for it in cash up front. However this is not standard practice. Companies operating in a retail industry usually rely on the cash flow from its products to pay off the short-term obligation.  Bud being such a dominant player in the brewers industry can negotiate favorable financing terms with suppliers. Make sure you compare ratios with companies operating in the same industry. It will allow you to put them on equal weighting. A current ratio below 1 for a small brewer company who is struggling to generate cash flow from operations is in greater risk than Bud. A smaller brewer in terms of market cap and customer base will not be able to negotiate favorable terms with suppliers and is likely have higher borrowing cost.

Quick ratio=Cash + marketable securities+ accounts receivable /current liabilities

The Bud quick ratio which  excludes inventory from the numerator declined from .65 in 2010 to .5 in 2010. Although the decline may signal weakness in Bud’s liquidity position, Bud can satisfy it current obligations from the cash generated from operations; and if necessary liquidate its inventory (beer) without having to rely on quick assets. On the contrary, companies whose inventories are high priced and discretionary such as jewelry companies will have a hard time liquidating its inventory and will need to rely on quick assets to meet their current obligations.

Times Interest Earned =EBIT/Interest expenses

Bud times interest earned ratio increased from 3.49x(10711.94/3048)  in 2010 to 4.36x(12681/2976) in 2011. Due to bud deep product portfolio, economies of scale and global presence Bud earnings is able to meet its interest payment on its long term debt.

EBITDA Coverage Ratio=EBITDA + Lease payments/Interest +principal payments +lease payments

Times Interest earned  gives us an indicator of a company to meet its interest payments on long term debt to avoid bankruptcy, companies also have other contractual obligations beside interest payments such as lease and principal payments they must honor to avoid bankruptcy. To ensure a company has necessary cash flow to satisfy all financial obligations, we calculate the EBITDA coverage ratio. EBITDA ratio  is a better measure than EBIT because it includes the cash flow available to meet all fixed financial obligations. Noncash expenses(depreciation, amortization and depletion)  is added back to EBIT because no cash is expended. Depreciation, amortization, depletion expense is basically a way to allocate the cost of using a fixed asset to the income statement. BUD EBITDA coverage ratio increased  4.27x (10711.94+2602.99/3064.48+8+40) in 2010 to 5.16x (12681+2750.01/2976.01+5+11). Bud EBITDA and lease payments are 5x greater than interest, lease and principle payments. Lease and principle payments can be found in  interest-bearing and borrowing section of a company annual report.

Debt to equity=Long-term debt/shareholders equity

A company can finance its assets in three by 2 ways by issuing debt or selling equity. A company that finance its assets with debt could be a greater risk if it cannot earn a greater return than the cost of using debt. Companies use leverage instead of equity to magnify their earnings. Selling in equity have the effect of diluting shareholders equity which can cause the EPS to decrease thus causing the stock price to fall. A company who is able to finances a portion of their assets  with debt and is earn a return greater than the cost of debt will increase the wealth of shareholders assuming operational expenses remain aligned with sales and equity dilution is prevented. Bud Debt equity ratio decreased to .92 (34598/37492)  from 1.19(41961/35259). In 2011, Bud used $0.92 from creditors for every $1 it had borrowed from investors to finance its assets. Conversely, in 2010 Bud used  $1.19 from creditors for every $1 it had from investors to fund its assets. Obviously, the lower debt to equity ratio the better. A company that whose capital structure consist of significant amount debt runs the risk of becoming insolvent if the cash flows generated  from operations  and earnings has been positive.

debt to capital ratio= Total Debt/Total capital

To get another look at how a company finances its assets, compute the debt to capital ratio. The numerator is defined as  short-term borrowings +current portion of long term debt +long term debt+ notes payable. Likewise the denominator is defined as total liabilities+ shareholder’s equity (the right hand side of the accounting equation).Bud debt to capital ratio declined to .3594($5567.01+$34598/$11754) in 2011 from .3952($2933+$41961/$113598). In 2010. 35.94% of its capital structure was financed by debt in 2011  as oppose to 39.52% in 2010. Although , the lower the  debt to capital ratio the better, make sure you compare it to other companies in the industry to get a better financial picture. The decrease in Bud debt to capital ratio indicates the company ability to rely less on leverage and more on internally generated funds( retained earnings and cash flow generations) to finance its operations.

Margin of Safety

To succeed as an in investor there must be a margin of safety present when looking to buy equity in a company. For example, you have determined that the intrinsic value a company stock is $70 and the stock is currently trading at $55.This stock looks like a bargain but the intelligent investor waits till the stock hits around $48. Why? Because the cash flows may not materialize for the stock value to appreciate to $70. The stock may actually be worth $64.A company intrinsic value can constantly change if it earnings and cash flow are unpredictable. Now do you see why Warren Buffett sticks to business he can understand with predicable profitability and business prospects. Calculating the intrinsic value of a company who earnings vary year over year with no enduring competitive advantage is daunting. You have a better chance of assessing a company’s intrinsic value by focusing on companies in your circle of competence. This will allow you to interpret information quickly about a company earnings and cash flow once you have done the research. Margin of safety is so essential and critical that Benjamin Graham stated “that to have a true investment there must be present a true margin of safety is one demonstrated by figures, by persuasive  reasoning, and by reference to a body of actual experience.”The margin of safety keeps your emotions in check when the markets are irrational in short term and protects you from capital impairment or deterioration.

To have a margin of safety you must understand how to value a business and the only way you can value a company is by understanding the business. To understand a business you must have a firm understanding of the company industry structure, its economic or business drivers, its products and services, business or competitive strategy ,its financial strength and profitability. Margin of safety and business valuation are inseparable concepts. Once your able to assess a company key drivers and quantify it  using discounted free cash flow, relative valuation, or the dividend discount model (if a company dividends payout resembles the profitability) the better investor you will become.

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