I Thought Operating Income was Conservative…

By LaurMG. (Cropped from “File:Frustrated man at a desk.jpg”.) [CC BY-SA 3.0 (http://creativecommons.org/licenses/by-sa/3.0)], via Wikimedia Commons

But I’ve decided that even Operating Income isn’t conservative enough when used for valuation.

The reason being that even though Operating Income is more conservative than Net Income due to the lower room for accounting manipulation, it’s still susceptible to accounting manipulation that masks the true picture.

An example is Exxon Mobil (3.41% of my net worth as of this writing).

If judged by a 5 year average Operating Income / (Market Cap – NNWC), it’s currently yielding at ~12% [1], which is a bargain for long term oriented shareholders (eg. The Operating Income maybe muted last year and for the next foreseeable 2-3 years, but Oil prices must rise again in the long term due to increasing demand globally).

But I don’t want to talk about speculations on when Oil Prices will rise and by how much, I want to talk about the shortcomings of Operating Income.

You see, even though 5 year average Operating Income / (Market Cap – NNWC), Free Cash Flow / (Market Cap – NNWC) is at an astonishing 3.02%[2]!!

The reason why this is astonishing is two-fold:

  • Free Cash Flow (FCF) is a company’s Operating Cash Flow – Capital Expenditures, which means that’s what shareholders would expect to receive after deducting from the Cash Flow what’s required to keep operations going if shareholders required the company to distribute 100% what’s leftover (a.k.a. True Earnings)
  • As of 2015-12 Annual Report, Exxon Mobil’s dividend / share is $2.88 while its FCF / share is only $0.98, which means the dividends are nowhere nearly as safe as the 60% payout ratio indicates

Which makes me uncomfortable, because what we’re looking at is a potential double whammy to my original Exxon Mobil investment thesis, which bet on Exxon Mobil using its disciplined capital allocation streak and strong balance sheet to make distressed investments. Based on the burn rate of dividends on FCF, it seems unlikely Exxon Mobil would be able to make any distressed investments without damaging its Triple A credit rating since the amount of cash needed to do both investments and pay an increasing dividend must come at a cost of balance sheet health deterioration due to the insufficiency of FCF to cover both activities simultaneously.

So I’m exiting Exxon Mobile (thankfully at a profit if I can sell at today’s price of $84.20), since I no longer see it as an attractive investment due to the better insight I have on hand.

And I will be looking at 5 year average FCF / (Market Cap – NNWC) in the future for any non-financial company for valuation.

[Footnotes]

[1] 5 year average Operating Income ($56.9 Billion); Market Cap (Mar 21st 2016 = $349.7 Billion); NNWC (2015-12 Annual Report = -$137.8 Billion)

5 year average Operating Income / (Market Cap – NNWC) = 11.67%

[2] 5 year average Free Cash Flow ($14.7 Billion); Market Cap (Mar 21st 2016 = $349.7 Billion); NNWC (2015-12 Annual Report = -$137.8 Billion)

5 year average Free Cash Flow / (Market Cap – NNWC) = 3.02%

 

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