Wild geese that fly with the moon on their wings,
These are a few of my favorite things
My favorite financial ratios combine a company’s efficiency at generating cash from its marketplace with a willingness to deliver cash to their shareholders. I focus on three indicators: Return on Invested Capital (ROIC), Cash from Operations divided by Net Income, and Shareholder Yield. It’s a fine theory, but how well does it work in practice?
Let’s compare two wild geese, the tech giants IBM and CISCO. They aren’t exactly the same, but they have similar business models—selling hardware, software, and services to other companies. Over the past 10 years, here’s how their financial ratios and total return looked:
Data Source: Bloomberg
Over the past ten years IBM has had a superior ROIC and has returned more cash to its shareholders. Its shareholder yield has been roughly 3% higher than Cisco’s, and their total return for the time period has been about 2% per year higher. Both companies appear to have similar ratios of cash from operations to net income. But analyzing how these ratios have changed over time provides even more insight.
Cisco started out with a 20% ROIC, and their stock boomed. But IBM gradually increased its ROIC from 10% to 20%, while Cisco’s went the opposite way, and their equity prices followed suit—until recently. But note their cash flow! Over the past decade, IBM’s cash flow to net income ratio has halved, falling from 2.0x to 1.1x. Recently, their free cash flow hasn’t even been sufficient to maintain their stock buyback program, and they’ve borrowed to support it. Obviously, this can’t continue: the balance sheet will become bloated, and ROIC will fall. This may be part of the reason why IBM’s share price has fallen since early-2013.
These indicators provide an interesting picture of why the equities of the two tech titans may have performed as they have. Both firms are solid, blue-chip companies committed to their shareholders, although their financials have diverged. We know that valuation matters, but economic performance matters too. Hopefully any silver, white, wintery problems they are having will melt into a spring of positive returns.
Douglas R. Tengdin, CFA
Chief Investment Officer