AuthorRohit Chauhan

Good article (free registration required) on mckinsey quarterly on how to evaluate performance, when the invested capital is low in a business (like IT services, FMCG, consulting services etc)

http://mckinseyquarterly.com/article_abstract.aspx?ar=1678&L2=5&L3=5

Some excerpts

A more useful way to measure performance is to divide annual economic profit by revenue.2 Grounded in the same logic as conventional ROIC and growth measures,3 this metric gives executives a clearer picture of absolute and relative value creation among companies, irrespective of a particular company’s or business unit’s absolute level of invested capital, which can distort more traditional metrics if it is very low or negative. As a result, executives are better able to evaluate the relative financial performance of businesses with different capital-investment strategies and to make sound judgments about where and how to spend investment dollars.

In application, this approach will vary from business to business, depending on what is defined as volume and margin. In a people business, such as accounting, the margin would likely best be broken down into the number of accountants multiplied by the economic profit per accountant. In a software business, however, it would be better calculated as the number of copies of software sold times the economic profit per copy of software; in this case, deriving the margin from the number of employees wouldn’t make sense. But in all cases, this approach can provide a more nuanced understanding of performance across businesses or companies with divergent levels of capital intensity.

Equally important, economic profit divided by revenue avoids the pitfalls of ROICs that are extremely high or meaningless as a result of very low or negative invested capital. Economic profit, in contrast, is positive for companies with negative invested capital and positive posttax operating margins, so it creates a meaningful measure. It is also less sensitive to changes in invested capital. If the services business mentioned previously doubled its capital to $20 million, its ROIC would be halved. But its economic profit would change only slightly and economic profit divided by revenue hardly at all (to 6.8 percent, from 6.9 percent), thus more accurately reflecting how small an effect this shift in capital would have on the value of the business.4

my thoughts : The above metric is not sufficient to evaluate. I would still consider a low capital intensive business superior compared to a capital intensive one , even if the above ratio is low , as a low capital intensive business could have higher free cash flow (provided both have similar competitive advantages ) and hence could be worth more.
The above metric is good to look at, but i would not base my decision on it (or any other single metric)

I have always wondered why analysts give price targets, when it is extremely difficult to predict the price level of a security, which is dependent on a host of factors with a few of these factors related to the psychology of the market at a future date.

The typical research report ( at least the free ones which I typically read) usually starts off with a very brief background of the industry. It would then discuss the latest results with a brief analysis of the last 2-3 years. The next 2-3 years income statement and balance sheet is projected. The report would typically end with a price target with simplistic analysis which is typically based on the projected EPS and a PE no.

The more rigorous analyst would give his logic for the PE assumed(often  based on the past PE of the company ). Most don’t bother to do even that.

PE as a measure is fairly flawed measure as it does not consider the ROE of the firm, its competitive advantage, impact of industry dynamics etc. At the same time the number used in backward looking (based on past PE, earning etc).I would assume a more rigorous mode of valuation would be based on DCF, with various scenarios being considered and valuation range being arrived at (with degree of confidence for this range).

But then the analyst is giving the consumer (the investor) what he wants – A precise price target (which would be hopefully achieved in the future) , a certainty,  where none exists.

It’s not that all analyst reports are of a poor quality. Some do discuss the industry in depth and attempt to do a more thorough valuation exercise. But most are superficial and not worth reading. I have found the original source of the information – The annual reports, far more useful than the analyst reports and have never made a serious commitment of capital based on an analyst report.

Do we have any good source of analyst reports in India? If you are aware please email me.,

For those interested in the discussion on brands and how strong, and powerful brands add value to a business, there is an article in fortune which discusses the top ten brands across the globe.

How to Build a Breakaway BrandHow ten companies, making products from drills to waffles, took good brands and made them much, much better.By Al Ehrbar
What do Gerber, Google, and Eggo have in common? They’re all selling familiarity, trust, and quality—those intangible traits summed up by the word “brand.” Right now that word is more important than ever before, because competitors are more instantly reactive and consumers more sophisticated than ever before. The Model T Ford was in production for 18 long years with little change; Sony’s Cyber-shot digital cameras go out of production while the packaging is still crisp. And once upon a time shoppers pretty much believed the hype; these days Internet-powered bargain hunters are armed with accurate pricing and product information—and brutal in their search for value.
In this cutthroat marketplace, which brands have been most successful? To find out, FORTUNE turned to Landor Associates, a brand and design consultant in San Francisco. Landor mined a huge database of brand perceptions called the BrandAsset Valuator, or BAV, to identify ten products that scored the largest increases in brand strength from 2001 to 2004. (Landor is part of WPP Group’s Young & Rubicam division, which owns the BAV.) Landor’s partner, the New York consultancy BrandEconomics, then calculated the pop in economic value each of these breakaway brands gave their parent companies.
Here’s how it works. First, Landor and BrandEconomics asked consumers—9,000 of them—what they thought of 2,500 U.S. brands. Then they looked at brand strength. This is a combination of two properties: differentiation and relevance. Differentiation is the degree to which a brand stands out. Relevance is the degree to which consumers believe a brand meets their needs. That all sounds rather obvious, but what’s surprising is that the two factors don’t necessarily go together. Rolls-Royce has stellar differentiation but hardly any relevance, since few people can pay $300,000 for four wheels. Kleenex is highly relevant but undifferentiated: Most tissues feel alike. The brands that do best are those that deliver on both counts.
In addition, the BAV measures a brand’s stature, which can also be broken down into two components—esteem and knowledge. Esteem is how well regarded the brand is, while knowledge refers to whether the consumer understands it. And once again, those two qualities don’t operate in lockstep. A high-esteem, low-knowledge profile may be a sign of a brand on the rise—the consumer’s curiosity is piqued. A high-knowledge, low-esteem profile, on the other hand, is the consumer’s way of dissing a brand: We know it, and it’s nothing special (think Dodge or Coor’s Lite).
Weakening brands tend to depend more on coupons and discounts; muscular ones can command a premium. How much does that matter? A lot. The intangible value of a company is its market value minus its tangible capital (i.e., property, plant, equipment, and net working capital). A BrandEconomics analysis found that companies with strong, well-regarded brands had an intangible value of 250% of annual sales; companies with listless brands had one of only 70%.
In important ways, though, the value of a brand is incalculable. A rising brand secures more customer loyalty, higher margins, greater pricing flexibility, and new opportunities for growth. And brands on the way up, BrandEconomics research shows, ride through economic downturns with less trauma. “The combination of faster growth with less risk,” says Hayes Roth, vice president for global marketing at Landor, “is business nirvana.” Here’s a look at ten brands that are pretty close to paradise right now.