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I've been seriously investing for about two years now, and have tried to learn as many basics as I could during that time, settling on value investing and the Buffett/Graham type of model, wanting to buy excellent businesses at good (or preferably cheap) prices. Along the way much of the effort has gone toward developing a suite of tools that can help screen companies well enough so that I would apply serious due diligence to only a small handful of promising candidates. The many initially disconnected ideas and thoughts uncovered in this time are slowly taking shape into a real strategy. For example, Buffett always says that return on capital is his major metric, since he has massive amounts of capital available and wants to find businesses that can take advantage of cash infusions with outstanding returns, while paying well below intrinsic value for them.

Probably the best-known approach to calculating intrinsic value is to estimate a firm's free cash flow, estimating its growth over time, and running a DCF on future free cash flows. It sounds simple but there are plenty of questions that come up right away about exactly what should go into that free cash flow calculation. But return on capital: what to use as the return, and how conservative to be in calculating total invested capital? Buffett's rule sounds simple but trying to really get a handle on how to do it proves very much otherwise.

I also thought that with a little software development and a reasonable source of company fundamental data I should be able to write some screens that would have a reasonable success rate of identifying companies to consider for further analysis (a couple have worked out nicely so far: the BMW Method screen ( and the HG-Type Screen with weekly postings in the Hidden Gems boards, described at The hard part has been to validate the basic business of a company–its free cash flow might look great but just where was that cash flow coming from? The company is selling for a historical bargain, but is there a fundamental reason why? And how could I eliminate companies from consideration that used heavy debt or equity to generate the cash? Buffett's return on capital seems like a good idea, but how to test for it?

Searching for ideas about how to answer these questions, I looked at this board again and it finally struck me! Of course! The simple concept of looking at a company from two angles, the defensive and the enterprising income statements, is the answer! Is the company able to fund itself (not requiring outside investment), and if so, is it consistently producing a good return on that cash infusion? Specifically, could I use these tests in an automated screen fashion that could run over about 8,000 companies and only pass companies that were within these constraints? If a quick scan of all companies could be done to find those passing both tests, or if the screen runs very quickly so that a candidate list from some other source could be run through the screen, it would be just great.

The spreadsheets that have been posted here are some amazing work by some truly talented Excel programmers. However, they take a lot of work to utilize properly, and are most useful once just a few companies have been identified for a much deeper look. So instead, I have tried to do a “best effort” defensive and enterprising income tests using a limited data source (AAII's Stock Investor Pro) but still catch the gist of the tests. I'll describe that screen here (and Hewitt might grimace a lot—it's quite limited against what he describes in the book) and I wonder if anyone has suggestions.

But first: I've written a preliminary version of the screen (running under Linux and written in perl) and am so far quite happy with it. It is rough and runs in a fraction of a second and gives the defensive and enterprising profits per share for up to the last 7 years for any stock in the SI Pro database. I have found excellent correlation between a company being profitable on IETC's two income statements and stocks that have done well over time. Some back testing also seems to show consistently good returns on companies passing, say, 2 or 3 years ago. Interestingly, the screen run on quite a few “Hidden Gems” or small company turnarounds show that many of them moved from other parts of the Earnings Power Chart into the Earnings Power Box in the last 1-2 years.

What I would really like to do is combine this screen with others that look mainly at valuation. The combination of a great company generating real returns on internally generated cash and selling cheap is the best investment!

Here are some of the questions. First of all, the SI Pro data has only the most basic elements of the financial statements. It does not separately break out CapEx into acquisitions, property, or potentially non-operating investments, so sometimes CapEx is a negative number (meaning a gain on a non-operating investment overwhelmed spending on others). Secondly, some data is sometimes just missing (Depreciation/Amortization frequently). What I am hoping to glean from this post is some ideas on whether the screen as implemented with the data that is available is doing anywhere near what it should be doing; and whether there might be better approaches or other suggestions.

Defensive Income Statement

The basic idea is to determine whether the company had cash flow available to fund its investments in the last year. Since SI Pro does not separately break out SG&A or Investment Income, I use IETC's “Defensive Profit in 30 Seconds” (page 63) which is simply to subtract spending on capital and acquisitions from operating cash flow. But even here, SI Pro's data is not perfect; CapEx is a single number, and there are no separate numbers for nonoperating cash sources to subtract out. So I use SI Pro's CapEx as investment spending, unless it is a net gain, in which case I look for last year's CapEx; if that is also positive then I use the current year's Depreciation/Amortization, and if that is zero then I just ignore CapEx. This final capitulation happens for roughly 12% of the companies screened, which isn't too terribly bad, and which I note on the screen output (it only happens on one of the 23 companies currently passing the screen). Then I divide the difference between Operating Cash Flow and this form of CapEx by shares to get defensive earnings per share.

Enterprising Income Statement

There are two major parts: calculating the total capital, and calculating the profit made from that capital after charging for interest on all the capital.

Total capital is simply stockholders' equity plus short term and long term debt, less short term investments and less cash in excess of 5% of revenue (I know Hewitt uses a 2% number, but I need something that applies to a wider range of companies; recent postings here have gone in a different direction that may actually be better anyway).

To calculate the enterprising profit, we need to estimate the total cost of capital. There are two components: interest on debt, and “interest” on equity. I attempt to calculate interest on debt by adding up all interest expenses for the year and dividing by total debt (long term and short term), but limit the rate to no less than 6% and no higher than 10%. “Interest” on equity is simply the interest rate on debt plus 6% (600 basis points). So the highest quality companies should get debt interest of 6% and equity interest of 12%, ranging up to 10% and 16% at the worst. Ideally these should be tied to the interest rates of high-quality bonds or 10-year Treasuries in some simple way.

These interest rates are applied to debt and equity and total “interest” costs are added together, forming the total cost of capital. In this case, equity is simply the total capital as calculated above, less all debt. This is multiplied by the equity “interest rate” to find the equity “interest” paid. Debt times the debt interest rate gives the debt interest we are charging. Note that I am not using the actual interest paid on debt as reported, but recalculating it in case the interest rate was forced to be within the 6% - 10% range.

Total enterprising profit is then after-tax gross income (with operating interest backed out), less after-tax interest on all debt both operating and non-operating, less equity “interest.” This is divided by shares to get enterprising profit per share.

Testing For Earnings Power Box

The screen calculates defensive and enterprising profits for between 3 and 7 years back depending on user preference. For each year, it will fail the company being screened if either profit is negative. For detailed reports it prints out, for each year, both profits, the accrued (reported) profits, and (as I like to see it) the location of the point on the Earnings Power Chart in polar coordinates (angle and radius, and the “quadrant” the point is in, quadrant “I” being the Earnings Power Box and increasing quadrant as you go counterclockwise around the chart) .

Other Tests

Earnings Staircase: both Defensive and Enterprising profits per share as a function of time (years) are fit to straight lines using a linear regression routine, and the slopes of those lines must be positive. This does a rough and simple recognition of a staircase pattern which doesn't have to be exact but has to show a general upward (staircase-like) trend.

The following tests are performed only on the last year being analyzed.

Debt Repayment: Total Debt divided by Defensive Earnings. Debt Repayment period must be less than 5 years.

Return on Greenest Dollar: The change in enterprising profit plus cost of capital from the previous year to this year, divided by the change in total enterprising capital. This must be at least 10% and neither quantity can be negative.

Valuation: share price must be no more than 15 times next year's estimated Defensive Earnings per share (based on projecting the fitted line).

Size: Market cap must be at least $30 million.

Industry: no banks or other financial institutions, metals or mining companies.


I am not sure how best to show results. One obvious thing is just to list the companies that pass this screen today (there are 23). Another is to show the results of a back test: the screen is run on 3-year ago data and the decision to buy the stock is made based on valuation 3 months after the end of the fiscal year. The price change since then is reported. Yet another is to run some current interesting prospects through the screen to see if they match in any way with what people are getting with spreadsheets. What I can also do is show the results of running the screen on similar data to what is in the IETC book, as follows. (The QUAD, RAD, and ANGLE columns should be familiar to people who work in polar coordinates but can be ignored; they don't add any new information that the DEF and ENT columns already contain.)

WWY 1998 0.73 0.69 1.31 I 1.00 43
WWY 1999 1.54 0.68 1.33 I 1.68 23
WWY 2000 1.38 0.78 1.45 I 1.59 29
WWY 2001 0.95 0.85 1.61 I 1.27 41
WWY 2002 0.74 0.89 1.78 I 1.16 50

Debt Repayment Period: 0.0 years
Return on Greenest Dollar: 15.2%

Here we see that Wrigley's IETC Profits for 2002 are both about 20-24% underestimated against what is in IETC: $0.95 in Defensive Profits vs. $0.74; $1.22 in Enterprising Profits vs. $0.89. And the return on Greenest Dollar is a little lower, 18% vs. 15.2%.

Here's Paychex (PAYX):

PAYX 1998 0.05 0.19 0.28 I 0.20 74
PAYX 1999 0.17 0.27 0.37 I 0.32 57
PAYX 2000 0.17 0.39 0.51 I 0.43 65
PAYX 2001 0.29 0.50 0.68 I 0.58 60
PAYX 2002 0.41 0.52 0.73 I 0.66 52

Debt Repayment Period: 0.0 years
Return on Greenest Dollar: 28.3%

PAYX shows a nice staircase pattern, but the Defensive and Enterprising profits are all about half or so of what is given in the book (page 128), indicating that the screen's simplified calculations can probably use some work.

The currently passing companies are as follows. This screen was run using 3 years of history, in other words the companies had to land for the last three consecutive years in the Earnings Power Box in a kind of rough staircase pattern, as well as pass the other tests described above for the last year. The numbers are Defensive and Enterprising Profits, and the ratio of share price to current Defensive Profit per share, a measure of valuation.

EMR 3.55 0.81 14.85
FDO 1.41 0.62 13.81
IMO 4.44 2.50 12.42
MMM 4.19 2.13 12.92
NVR 58.89 58.14 10.99 (could not find capex data)
OXY 3.96 3.33 13.88
PETD 1.79 1.28 13.42
SAFM 3.67 2.56 8.29
CEC 2.22 0.98 13.30
TBL 2.23 1.41 14.37
CAJ 3.21 1.61 14.69
NVO 2.79 0.65 14.03
ERES 0.60 0.50 14.29
CECO 2.23 0.61 13.52
DOCC 0.66 0.32 9.94
PKZ 4.52 4.77 5.26
TLK 1.35 1.07 13.17
XOM 3.94 1.86 11.66
AEY 0.44 0.39 7.03
MTLM 3.59 1.52 4.47
JRN 0.85 0.28 13.60
KAR 1.61 0.16 14.42
WTI 1.49 1.65 11.38

A little bit of checking on these shows all of them to be apparently quality companies generating real cash.

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