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I posted this note on Tom Jacob's and Jeff Fischer's Complete Growth Investor board last night, and thought readers here might also find this information useful. - HH


With the markets melting faster than ice cream in the August sun, it is natural to feel helpless.

What to do?

1. Exercise.

2. Keep an active social life.

3. Estimate the Earnings Power Euphoria Ratio for each company you own. The less euphoria, the safer your portfolio from a valuation perspective.

To illustrate, let's look at Seaboard (SEB), which has food processing and shipping interests.

Key data:

Stock price: $1,850
Shares outstanding: 1.26 million
EPS: $203
Tangible book: $949
5-year growth rate: 7% (my estimate)
Discount rate: 10%

The first thing we do is subtract SEB's tangible book value from the stock price. $1,850 - $949 = $901. Thus, $949 of SEB's $1,850 stock price is explained by its "hard" corporate net worth, and the other $901 by future earnings.

Next, subtract projected cumulative earnings over the next five years from this $901 figure above. Given my estimate of an annual 7% growth rate and a 10% discount rate, the present value of SEB's next five years' worth of earnings is $935. Since $935 is greater than $901, SEB's Euphoria Ratio is 0%. Between SEB's net physical assets and the next five years worth of EPS, you more than cover the $1,850 stock price. Investors are not keen on this business, you can say.

Now let's look at Google. Google is a superior company to SEB, no question. But what about valuation? There is, after all, a difference between a good company and a good stock.

I estimate GOOG's euphoria ratio at 68%, based on data from Yahoo and the company's latest 10-Q filing. This is a pretty high number. I own GOOG and I am not going to sell it. On the other hand, GOOG is a small percentage of my portfolio. I do not want to own a lot of companies that have similar Euphoria Ratios. The valuation risk is too great.

Blue Nile, which I owned until management started touting a misleading free cash flow number in Spring 2006, has a Euphoria Ratio of 80%. I am getting altitude sickness!

A caveat. A key element here is the growth rate. But analysts are terrible prognosticators, as David Dreman's research finds. This is why we want to stick with companies with low Euphoria Ratios...we give ourselves a margin of safety in case sand gets in the ointment.

If you are able, estimate your portfolio's weighted average Earnings Power Euphoria Ratio. Mine is 29%, which means 71% of the stock prices of the companies I own weighted in proportion to the stock prices of all other companies in my portfolio is explained by a combination of tangible book and the next five years' worth of earnings. The other 29% is explained by earnings beyond year 6. While I do not like what is happening to my portfolio right now, the low Euphoria Ratio gives me peace of mind.

I will talk more about the Earnings Power Euphoria Ratio at CGI Las Vegas.

To sum up, don't get fearful. Get analytical. The more you know about your companies, the better your investment results.


Hewitt

long SEB and GOOG
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Blue Nile, which I owned until management started touting a misleading free cash flow number in Spring 2006, has a Euphoria Ratio of 80%. I am getting altitude sickness!


Hi Hewitt

Can you elaborate on the misleading cash flow?
Blue Nile is my current poster child for crazy valuation.Selling at a huge premium to other jewelers with a PE of around 115 and EV/EBITDA of 50 I can't understand the fascination. Growth is decent at 20% EPS growth yoy last Q2 but is it worth the current price? Sounds like you sold too soon :(

True Religion is a strange company. Looked at them around 2 years ago IIRC and they have gone nowhere--essentially flat. At the time the co was only a designer and manufacturer and had just decided to open one store in LA. Sounds like they are up to 11 stores now. The management was self-intersted and had no shame taking stock, bonuses and big salaries. They struck me as a shade sleazy. of course sleaziness is not necesarily an impediment to big earnings. My largest concern was the durability of the $350/pair distressed denim pants market. Seemed like a fad about to depart. Also management had kicked around LA in the 70's and 80's in a few failed businesses and I saw no reason to trust them with an empire of stores. but if the stores are successful and if they have moved beyond slashed ripped and stonewashed denim and have their fingers on the pulse of the next big fashion trend they might be worth a look. Earnings always were pretty good.

Will look forward to hearing all about the euphoria ratio. From what I can see there is a lot of it about in spite of the market dips.

>^..^<
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No. of Recommendations: 10
>^..^<

Can you elaborate on the misleading cash flow?
Blue Nile is my current poster child for crazy valuation.Selling at a huge premium to other jewelers with a PE of around 115 and EV/EBITDA of 50 I can't understand the fascination. Growth is decent at 20% EPS growth yoy last Q2 but is it worth the current price? Sounds like you sold too soon :(


Not Hewitt, but have written on the subject once-or-twice...

http://newsletters.fool.com/04/online-exclusives/updates/2006/04/17/060417x7l6u5n.aspx
http://www.fool.com/investing/small-cap/2006/09/28/the-dark-side-of-stock-buybacks.aspx
http://newsletters.fool.com/04/online-exclusives/updates/2007/02/15/ctrp-nile-ufcs-radn-praa-cryp-dw.aspx
http://newsletters.fool.com/04/online-exclusives/updates/2007/05/09/hg-weekly-nile-cmg-b-cab.aspx
http://newsletters.fool.com/04/online-exclusives/updates/2007/07/19/hg-weekly-stly-nile-mrh.aspx
http://newsletters.fool.com/04/online-exclusives/updates/2007/08/09/hg-weekly-nile-uti-oyog-cab-and-more.aspx
http://newsletters.fool.com/04/online-exclusives/special-reports/2007/06/29/the-many-faces-of-free-cash-flow.aspx

What I think has been really neat to watch about NILE is not the woes of those who might have "sold too soon" (a strange statement, in my mind, since, if you realize a company you own is, after-the-fact, engaging in misleading behavior misaligned with your own investment interests, it cannot - I believe by definition - be termed "selling too soon" without benefit of hindsight...and my crystal ball doesn't work very well).

Rather it is the ever greater assumptions that are getting trotted out to justify the investment case TODAY. The last analyst (that I saw) that jumped on the upgrade bandwagon (Citigroup) set a price target of $88, or 52 times his 2009 earnings estimates. He did so when the stock was trading around $79, meaning he was calling 'Buy' on a stock that he expected an annual return on of less than the 2-yr T-Bond (then yielding 4.86%).

Of course, the stock promptly ran to $98 in the weeks following earnings.

All the while, insiders have been cashing out:

* CEO Mark Vadon reduced his stake from 1.406MM shares to 1.011MM shares from 1-Jan-07 to 14-May-07 (a 28.1% reduction).

* CFO Diane Irvine reduced her stake from 115.8K shares to 40.4K shares from 1-Jan-07 to 31-May-07 (a 65.1% reduction). Moreover, if you back up two months to 8-Nov-06, her stake has sold off from 186.9K shares, down to 40.4K (a 78.3% drop).

* Sr VP Gaston Dwight dropped his stake from 15.5K to 1.3K in 2007-to-date.

* Sr VP Susan Bell has liquidated her entire position in 2007 (12K shares) which she'd largely maintained for the past few years.

Meanwhile, all of the $0.25 strike options that everyone and their dog got prior to NILE's IPO continue to exercised into reality, replacing the much-touted share repurchases. If you subscribe to the concept of 'Unfettered Free cash Flow' (described in the above links as punishing so-called free cash flow for the impact of buybacks completed ostensibly solely for the purpose of offsetting option dilution), then NILE trades today at 58 times unfettered Free Cash Flow; and I'm even generous enough to add back the non-cash stock-comp expense before I do the unfettered calcs.

And should we highlight that the company repurchased exactly zero shares in Q2-07 when the share price fluctuated between 40.53 and $62.30 (it's $87.50 as I type this). Why might the repurchase program have been halted? Could it be that management, share compensation gorge-monkeys though they may be, actually understand the value of their own shares?

From the Q2 conference call:

"I guess what we'd like for everyone to understand about the share repurchase program is we'll
always be very thoughtful in how we execute that program. Certainly looking at our balance sheet
opportunities for investment, you know we need to be very prudent from a capital allocation standpoint
and make the right decisions in the buyback program. We want to always do what's right for our
shareholders. And I think we've done that. In the past 2.5 years we have retired 15% of our
outstanding shares. Today we have more cash on our balance sheet than we did even after becoming
a public company. So over time that will continue to be a very strategic program for us."


Interesting stance on capital allocation, I think, for a company so famously capital light (they expect to spend $5MM in CapEx for all of 2007 - a number that contains several significant growth initiatives, versus 2006's CapEx of $1.9MM, and the widely-cited negative working capital structure). Of course, there are those out there who argue that share buybacks are always a worthy use of shareholder capital; a wrong-headed, but somewhat common stance, IMHO.

And yes, while they have repurchased 15% (actually 15.2%) of outstanding shares in the past 2.5 years, what they fail to mention is that, over that same period, about a third of those shares have already been returned to the market via option exercises, there are roughly 1.95MM options still outstanding (including roughly 400K at a strike of $0.25 - no, not a typo) - all well ITM, and management has flat-out stated they intend to continue issuing 3% of the company's equity annually in the form of options.

But, you know, the company is growing revenues at 25% annually (past 3 years), so all is good, right?

Sorry for all the NILE BILE (heh), but I think it's important to recall that Hewitt's IETC process is actually a tri-phase approach:

1) Assessing Earnings Power/Quality
2) Assessing Competitive Advantage
3) Valuation

When I look at NILE (a company I actually really like - which is probably why all this bugs me to no end), I think it's a company that does reasonably well by the QoE and EPC charts, as well as on competitive advantage, but is a woeful, woeful, failure on the valuation front.


Cheers,

Jim
(P.S. Nice to see this board get active again - Hewitt, sorry I probably won't see you in Vegas!)
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Jim,

I agree with everything you wrote. Being one of those who sold at what I thought was an overvalued price only to see the price keep climbing (http://boards.fool.com/Message.asp?mid=25763668), I have to say I'm going to adjust my selling criteria just a bit.

You know that phrase, "The market can stay irrational longer than you can stay solvent." Same kind of thing with Blue Nile, just applied to a different situation. With 20/20 hindsight, what I should have done is either sold a portion or watch it like a hawk as it continued to rise until I could stand it no longer. Maybe (gasp!) use a stop-loss sell order for this type of situation. I'm positive that my valuation about what was needed back at $55 was a lot more reasonable than any valuation or expectation baked in now. The fact remains, though, I'm out $30 or more per share.

I'm (slowly, but getting there) coming to realize that valuation is the weakest of my list of reasons to sell a company, because Mr. Market doesn't have to agree with my model.

Cheers,
Jim
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Hi Jim,

I'm (slowly, but getting there) coming to realize that valuation is the weakest of my list of reasons to sell a company, because Mr. Market doesn't have to agree with my model.


I agree with pretty much everything you've said, both here, and over in HG. I think my particular bug-a-boo (not being a shareholder) is that I'm not facing the 'sell' side of the equation, and being on the 'buy' side, the farther that NILE has run up, the more bullish I see folks (with the exception of HG, where I think I've historically poured enough cold water on the company).

The example I've used in a couple of places is Quality Systems. Formerly owned that one. Made a 4.5-bagger on that one between capital appreciation, and selling calls when I thought it had run too far. The stock, of course, ran about $30 past my call strike price, and I let it go (the company has since split 2:1).

QSII, as you know, is a darling of SA, and the first two recommendations were at just dumb valuation levels. Problem was, by the time of the third recommendation, the company had been rather significantly bid up, and the multiples people were paying had more than tripled (at the second recommendation, investors were paying about 17x owner earnings....at the third, over 58x). But thing was, the euphoria (harkening back to Hewitt's original theme) that met the third rec was palpable; investors looked at the magnificent returns of the previous two picks, and extrapolated that from the third; returns that would have required similar expansion to, say, 200x owner earnings in order to accomplish.

It's been nearly two years, and that third rec has underperformed the market nearly 20%. Not because QSII is a bad company (indeed, far from it - their hiccup of a quarter last week has me nearly ready to jump back in again...if it can only get a little cheaper). But because, as the value chorus is wont to say, "Price Matters".

With QSII there had been some clashes at the board level, and some attempts at sweetening the executive comp. But you still had two guys owning nearly 40% between them, a terrific cash flow engine, and a huge market opportunity.

At NILE, you don't have the board issues, but the exec comp is...well...generous; more generous than QSII had been. You have a similarly terrific cash flow engine, by all accounts a great opportunity, and excellent management execution. However, you also have a higher (relative) price than QSII at that point, slower growth (it's true) than QSII at that point, narrowing margins versus widening margins then at QSII, and analysts tripping over themselves to upgrade. And QSII had begun returning some of that tremendous cash generation via dividends, versus via repurchases at premium prices.

QSII has gone pretty much no where for the last 7 quarters, during a period when the stock market as a whole has done pretty well. And I fear that is to become NILE's fate; that investors buying now are captivated by the dazzling returns of the past, and won't receive commensurate forward returns.

Anyway, while I advocate the "sell almost never" mantra (particularly for what I term 'core' portfolio holdings, I'm not sure that what I know about NILE's management compensation ethos, and misleading manner of free cash flow presentation would have ever let me regard them as 'core'. Thus, if someone sold for a 'good' reason, at a valuation they felt 'overly generous' in the past, then I say job well done! And shun that hindsight bias telling us we've "lost" money (difficult, I know).

Best,

Jim
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I'm not sure that what I know about NILE's management compensation ethos, and misleading manner of free cash flow presentation

Hi Jim,

I think "know" is too strong a word there, Jim :-) it's just your opinion!!

I agree that they should not present FCF at all, but once they made that decision the method applied is the simplest and most widely used one. Any one method does not suffice, but it becomes too complex and confusing to present multiple methods. As long as they are consistent, and do not drop presenting FCF when the method becomes less favorable (as it will do shortly) I think that is fine. Analysts and investors can choose to take note or ignore the extra information as they wish. The main benefit is to generate analyst discussion and questions on cash flow performance.


Cheers

Mike
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An update to my post yesterday, specifically, this section:


All the while, insiders have been cashing out:

* CEO Mark Vadon reduced his stake from 1.406MM shares to 1.011MM shares from 1-Jan-07 to 14-May-07 (a 28.1% reduction).

* CFO Diane Irvine reduced her stake from 115.8K shares to 40.4K shares from 1-Jan-07 to 31-May-07 (a 65.1% reduction). Moreover, if you back up two months to 8-Nov-06, her stake has sold off from 186.9K shares, down to 40.4K (a 78.3% drop).

* Sr VP Gaston Dwight dropped his stake from 15.5K to 1.3K in 2007-to-date.

* Sr VP Susan Bell has liquidated her entire position in 2007 (12K shares) which she'd largely maintained for the past few years.




Since the Q2 earnings release lock-up period has passed, all of the aforementioned parties have engaged in NILE share transactions.

* CEO Mark Vadon further reduced his stake by 323K shares to 686K shares. To-date in 2007, he has liquidated 51% of his holdings.

* CFO Diane Irvine exercised and sold options ($0.25 strike, sold for $92+). Her holdings remain at the numbers presented in the prior post.

* Sr VP Gaston Dwight sold his remaining shares, and now holds position in the company. He also exercised and sold some options.

* Sr VP Susan Bell exercised and sold options ($0.25 strike, sold for $93+). She continues to own zero shares.


FWIW.

Jim
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Hey Jim

Thanks for the links--excellent insightful series of articles as usual.
I would have been highly surprised if NILE had bothered to adjust for deferred tax assets or options. It would have shown extraordinary attention to detail which you never see in companies reporting free cash flow.After adjustments NILE is cash flow positive so that part is not terrible. It's what you expect from companies reporting cash flow--no true accounting for real adjusted cash flow. I always take it fwiw--zero. I was hoping for some very juicy out and out plain wrong and misleading manipulation *sigh* I love accounting malfeasance.

What is striking is the notion that no price is too high to pay for NILE or Chipotle or a handful of other TMF stocks that ride the wave of positive sentiment and momentum. It sounds so 2000. There was a thread somewhere at HG where folks were lashing themselves for selling on valuation concerns for some HG stocks-- valuation is becoming an antiquated and somewhat frumpy approach to picking and holding stocks. In hindsight its always obvious--how much would you have paid for Iomega at the top? As helpless captives of daily double digit price gains that seemed to go on forever how could you sell or having sold, how could you live with your stupid decision? I see similarities to historical precedents and the attitude that no price is too high to pay for some companies just seems wrong.If you think value matters and its going to be a long hard haul to get NILE to live up to 115X earnings at 20% growth, then maybe it was right to pass at $98 and avoid the $16 downdraft.

There is also no doubt that NILE will crack $200 per share (since I am not a buyer) and I will wish I had bought at $98. I am the idiot that passed on Google at $175

NILE: 82.00
Down!
-4.50 (-5.20%)

Previous Close 86.50
Market Cap 1.29B
P/E 94.25
Volume 346,669
Day's Range 82.00 - 89.48
Avg. Volume (3m) 388,806
52-Week Range 33.05 - 98.50
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KitKat,

You know who's not lamenting selling their NILE?

http://boards.fool.com/message.asp?mid=25794343

Jim
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Hey Jim

I think the point is well made about cashing in options 9 years ahead of schedule by VP of finance is a good one.

Those that cashed in at $98 are no doubt pretty chuffed with their timing after the 21% decline
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"To illustrate, let's look at Seaboard (SEB), which has food processing and shipping interests.

Key data:

Stock price: $1,850
Shares outstanding: 1.26 million
EPS: $203
Tangible book: $949
5-year growth rate: 7% (my estimate)
Discount rate: 10%

The first thing we do is subtract SEB's tangible book value from the stock price. $1,850 - $949 = $901. Thus, $949 of SEB's $1,850 stock price is explained by its "hard" corporate net worth, and the other $901 by future earnings.

Next, subtract projected cumulative earnings over the next five years from this $901 figure above. Given my estimate of an annual 7% growth rate and a 10% discount rate, the present value of SEB's next five years' worth of earnings is $935. Since $935 is greater than $901, SEB's Euphoria Ratio is 0%. Between SEB's net physical assets and the next five years worth of EPS, you more than cover the $1,850 stock price. Investors are not keen on this business, you can say."

Forgive me for being slow, but how do come up with the present value of SEB"s next five years worth of earnings is $935? I must be doing something wrong. No matter how I run the numbers, I'm not getting $935.....

If anybody knows, help me! It doesn't have to be Hewitt. Thanks!
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If you (or any other reader) can teach me how to copy a table from my SS, I am happy to show you.
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Here's a post I found that explains how to do it. Basically you copy and paste your spreadsheet into a text file and then put a "< pre >" at the beginning and a "< /pre >" (both without spaces) at the end, which should keep your spacing.

I am trying to include tables for income statements, cash flow and balance statements in a post. No matter how nicely it is alligned when I paste it from Appleworks, when it ends up on TMF it is gibberish. Any way to cut and paste or do I go through the agony of typing it in?

Cut and paste of tables into HTML is usually not transparent. For the case of TMF, you should enclose the text with the lines "< pre >" and "< /pre >" (both without any spaces) to preserve fixed-width spacing. For example:

< pre >15268 2924 328 123 21839 1291 2391 22 11< /pre >
looks like:

15268 2924 328 123 21839 1291 2391 22 11
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Tabs as spacing elements do not work, just spaces.

There used to be a macro available on one of the boards that would take part of an Excel spreadsheet and format it for posting using the <pre> and </pre> tags, but I do not know where it is off the top of my head.

I think a quick(ish) way would be the following:
     • Copy the portion of the table and paste it into Word. A landscape format is good as the width of a single line is larger that way.
     • Convert all the text to a monospace font such as Courier.
     • Find and replace all tab characters with 3-5 spaces.
     • Touch up the columns.
     • Copy the result and paste into a posting window using the <pre> tag at the front and the </pre> at the end.
     • Preview the message and edit as necessary.

That's what I have done in the past, at least.

Cheers,
Jim
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If you (or any other reader) can teach me how to copy a table from my SS, I am happy to show you.

I see a few people have responded already... I think I have slightly easier way though.

- From excel, go to File->Save As
- In the pull down menu for "save as type" select "formatted text (space delimited)"
- Hit "save"

Now you have a text file saved where the formatting of the cells in excel has been automatically converted to spaces for you. Open this in any text editor... word pad, notepad... probably even word works. It should require minimal cleaning up if any.

- From the text file, select and copy the table and paste it in between < PRE > and < /PRE > tags (except leave out the spaces... those were only included to make the tags visible in the message) in your post. It will look like a complete mess when you paste it in, but when you click on "preview message" you'll see that it looks just like it did in the text file or in excel.

Hope that helps.
kevin
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No. of Recommendations: 1
Jordan,

Start with year zero's earnings of 203. For each year:

[ 203 * (1 + .07)^n ] / (1 + .10)^n

where "n" is year 1,2,3,4,5.

The first part of the formula is the future value at 7% growth, and the second part discounts it back to the present at 10%.

It adds up to 935.

-joe
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Bookmarking this page!

Just tried it as a test and it works beautifully! Thanks, Kevin. Much easier than my method.

Now a tip in return, though probably not as handy.

To get a HTML tag to appear without any intervening spaces, insert a real, invisible tag between the opening symbol and the rest of the tag. I usually use the "close italics" tag. For instance, <</i>PRE> will show up as <PRE> without the need for spaces and telling the reader to take those spaces out.

Cheers,
Jim
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To get a HTML tag to appear without any intervening spaces, insert a real, invisible tag between the opening symbol and the rest of the tag. I usually use the "close italics" tag. For instance, <PRE> will show up as <PRE> without the need for spaces and telling the reader to take those spaces out.

Hmm, didn't know that would work. It works because of the way the TMF website pre-processes the message when posting. In case they ever changed this, it may be useful to know the HTML-correct method, which should work anywhere.

< → & lt ;
> → & gt ;

There are no spaces between the ampersand, the code (gt), and the semicolon. You can easily see what it'll look like by previewing your message. Here's a link to lots of other special characters, including that little arrow I used just for fun:
http://graveyard.maniacalrage.net/etc/special/

Enjoy.
-joe
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Thanks Joe! I now see what I was doing wrong.
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Thanks Joe and Jim... more good stuff.
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