(Intermittingly I’m going to write a series of future blogs comparing the internal Model Price math on S&P 500 type companies (Large Cap) for comparison purposes. Usually this will highlight CEO’s who have done a good job in helping their company achieve a concept, which I define below as “economic velocity” and highlight CEO’s who haven’t performed well according to the numbers. Along the way of having fun with model price math and what it discloses, I will highlight some philosophical questions incorporating larger economic issues. I will call this series “Cage Match”)
What makes a “good” CEO?
How does one define a “good” CEO from a “bad” one? One definition is what I call “economic velocity” of a company. What is “economic velocity”, you ask? We can guess a company has “economic velocity” by the following attributes. The company seems to do no wrong. Earnings are increasing and the stock price is hitting new highs. I’m sure employees are doing high fives as well. Business magazines want pictures and interviews. Television producers are on hold. I guess if I say Apple Computer, you can picture my concept of “economic velocity” easily. But the question I have “Is this just lighting in a bottle?” In other words “Is this just luck, right time, right place for the man (sorry ladies) in the corner office?” Or is it hard work, special knowledge that CEO’s possess? Haven’t you always wondered? I have. These questions drove me crazy in the past.
Home Depot (HD) versus Lowe’s Companies (LOW)
Let’s compare two companies in the same industry. Home Depot has been on fire, stock appreciation wise, returning 76% over the last year – textbook “economic velocity” if you will. Lowe’s seems to be stuck in the mud. Why does the market like HD over LOW’s? Let’s have a look at the model price math to figure out what is going on here. First, let’s have a look at the long-term model price charts of each company.
Home Depot with monthly price bars, EBV Lines (colored lines) and model price (dashed line)
Note the EBV lines of Home Depot. Remember EBV lines reflect the growth in net worth of the balance sheet. See the decline in the lines in 2008, and the relative flatness since then. This indicates the non-growth of theoretical earnings (TE) (see my discussion of TE below), even though the company was making net income. As you can see our calculation of model price confirms the move in HD’s stock price. Also theoretical earnings (TE) are used in our model price calculation.
Lowe’s Companies with monthly price bars, EBV Lines (colored lines) and model price (dashed line)
Note the upward sloping EBV lines, compared to Home Depot’s EBV lines. Simplistically suggesting theoretical earnings (TE) are also trending upward.
As the reader can see back in 2008, both HD and LOW’s were trading roughly at the same valuation – EBV+3. So let’s have a look at the background data to see what is going on to make an assessment of why Home Depot is doing better then Lowe’s in terms of valuation. In the charts below we can see, that earnings for each company are almost back to cyclical highs, which occurred back in 2007.
Readers will see that in Home Depot’s case the stock’s current valuation has exceeded valuation highs posted in 2007, even though cyclical earnings have yet to surpass 2007 highs. Interestingly in the case of Lowe’s earnings even though close to cyclical highs however there is little growth in model price and current valuation is just over EBV+3. Just looking at earnings may lead investors to think LOW’s maybe mispriced? Or is HD overpriced?
One additional comment, if I may, if Lowe’s had the same valuation as Home Depot, Lowe’s would have an additional market value of some $40 billion dollars. What is important to note here is the market is not a zero sum game. In that Lowe’s could increase their market capitalization by $40 billion and not take $40 billion away from anybody else. Public equity markets are truly wealth creators, if companies – CEO’s – can get their math correct.
Enter Theoretical Earnings (TE)
I talk about Theoretical Earnings under the “Key Concepts” tab of this blog. We calculate theoretical earnings for every company in our database. I have included our theoretical earnings on the above graphs highlighting earnings per share of each company. To make it easier for everybody, including myself, we have made the two data series of each company into a ratio. Below are the charts on both companies.
You can see the difference between each company. The CEO of Home Depot is not only increasing earnings but also lowering theoretical earnings at the same time. What does this mean? Mr. Blake is increasing earnings with less or decreasing capital from the balance sheet of the company. From my observation and years of experience using this math the market sends signals in terms of higher valuation from this combination. However, look at Mr. Niblock at Lowe’s. Yes, he is increasing earnings as one can see but his theoretical earnings of his company are going up faster then expected earnings gains. The market, in my estimation, takes a dim view of this.
Knowing, Not Knowing the Math – The $40 billion dollar Question
So assuming the financial world doesn’t have theoretical earnings, my experience tells me that some CEO’s are better equipped then others for their jobs. The “good” CEO’s are the ones who leach-out capital from their organizations balance sheet both financially and operationally. Examples of financially reducing their theoretical earnings include share buybacks, paying dividends or extraordinary dividends when excess capital is residing in their companies and an acquisition policy that contributes to earnings more then the increase in the company’s balance sheet thereby increasing theoretical earnings (R+P). Examples of operational efficiencies include increasing turns in inventories – six sigma stuff, better placement of store locations, and international expansion.
Answering the Question, Who is the “Good” CEO in this Cage Match Situation?
Well I think we both know the answer to this question. Model Price math is an easy determinate in quickly assessing who is doing the better job, unfortunately the market is already ahead of us in terms of rewarding valuation. Large cap stocks can be profitable for investors, when a “good” CEO takes over a large underperforming company, performs a turnaround (getting the math right) and everyone seems to be rewarded, the CEO, shareholders, and the economy in general with a higher stock valuation.
However which company is the better investment going forward?
The fun of these Cage Match comparisons is what will happen in the future. Will Lowe’s shareholders and directors put up with this underperformance for long? Will Home Depot, and in particular Mr. Blake, continue earning gains with lower TE further expanding valuation of Home Depot or was Mr. Blake just lucky over the past few years? Which investors will outperform going forward, Growth/momentum investors through holdings in HD or quasi value investors in hopes of a LOW’s turnaround to HD’s valuation? This will be fun to revisit to see what happens.
Let’s hope Lowe’s can get their math right soon, or Mr. Niblock will be looking for work or giving up some of his titles. From the proxy statement:
Mr. Robert A. Niblock from 2004 to present – Chairman, Chief Executive Officer, President and Chairman of Executive Committee.