How to Read the Performance & Valuation Prime Chart
The Importance of Embedded Cash Flow Expectations
Embedded in every company’s stock price is the market’s forecast for the future performance of the
firm. If the company beats that performance, the stock price goes up relative to the broader market.
If the company fails to meet that performance, the stock price falls.
The Performance and Valuation Prime Chart in one place helps explain the company’s corporate
performance over the past 10 years, the value the market has ascribed to the company historically
and currently, while also explaining how the company has performed relative to the market.
This is an ideal starting point for the understanding of a company’s operational and market
Reported financial statements are a mess and earnings can go up and down because of hundreds of
“non-cash” items that can make it extremely difficult for any investor to figure out. Thankfully,
cash is still king. In the long run, the stock market prices company stocks based on the cash flow
generating ability of the firm, not the accounting-distorted earnings.
For a long-term fundamental investor, understanding the embedded cash flow expectations in the stock
price is key. The reported earnings may or may not even be relevant. As we see so often, there are
companies with negative earnings that are priced with enormous valuations, and companies with solid
earnings that are priced so cheaply. The problem is the inconsistency in the earnings.
Performance and Valuation Prime Charts were built to provide three cash-based assessments of the
market’s valuation. These are based on cleaned-up, scrubbed, cash-based V/E’ multiples, V/A’
multiples, and DCF or Discounted Cash Flow models. An investor can better judge a stock as
“expensive” or “cheap” when the accounting distortions have been removed and valuations have been
triangulated across these three models. (Note: the apostrophe after the V/E’ and V/A’ is the symbol
for “prime,” meaning “adjusted.” These calculations have been modified with comprehensive
adjustments to remove accounting and computation distortions found in traditional calculations of
The ROA’ Panel Shows Historical and Forecasted Company Performance
ROA’ is the abbreviation for “Return On Assets Prime.” The ROA Prime is a measurement that is
calculated after the balance sheet, income statement, and statement of cash flows have been
thoroughly adjusted to create an apples-to-apples set of financial information. An advanced ROA
computation is then applied which corrects for many formulaic biases and flaws in traditional Return
on Asset and Return on Capital Employed computations. Hence, the name “ROA Prime,” with the
mathematical notation for “prime” as ROA’.
The ROA’ explains the cash return that management generates on each dollar of cash it invests into
the company. For this reason, the term ROA’ is used interchangeably with the term “cash flow
return,” or simply, “returns” of the company or business. (For more, see the Institute’s
publications, “When Cash Is Not Cash and Why” and “How to Calculate an ROA”)
The ROA’ panel of the Performance & Valuation Prime™ Chart demonstrates the firm’s annual cash flow
returns over a decade of history. Two forecasted years are shown after the last full fiscal year
(“LFY”), both marked with an 'E' to indicate that they are estimates. Calculations are based on
publicly-available consensus analyst forecasts of firm sales, net income, capital expenditures, and
other information. These are the Institute’s assessment of what consensus analyst estimates suggest
for forecasted ROA’s.
Of utmost importance is the “Mkt” bar representing the Market-Implied ROA’ which is the last bar in
the bar chart, and shows in white when viewing the chart in color. This Market-Implied ROA’ is
determined by solving for the ROA’ that is the “embedded expectation” of the current trading stock
price level. The Institute’s computation takes readily available public information and “backs into”
the long-term ROA’ forecast implied by the stock price. This is incredibly valuable for assessing a
company’s potential stock price upside/downside.
On the next page, we delve into various nuances of understanding ROA’ levels, relative to the
company’s stage in business life cycle, cost of capital, corporate averages, and forecasts.
Understanding ROA’ Levels and The Importance for Business Strategy Evaluation
The ROA’ explains the cash return management generates on each dollar of cash it invests into the
company. The ROA’ is Earnings Prime divided by Assets Prime, with many adjustments to remove
accounting distortions. The term ROA’ is used interchangeably with the term “cash flow return,” or
simply, “returns” of the company. For more, see the Institute’s publications, “When Cash Is Not Cash
and Why” and “How to Calculate an ROA.”
The ROA’ is fundamental to understanding where a firm is in its life cycle, relative to its cost of
capital, and knowing how that should impact the firm’s business strategy. Early stage companies tend
to generate an ROA’ below their cost of capital, betting that future ROA’s will be far higher than
the cost of capital. More mature firms can demonstrate higher ROA’s.
Companies that generate an ROA’ above the cost of capital are creating value above the required rate
of return of their Assets Prime and should thus be grown so long as the incremental rate of return
on new capital spending continues to be above the cost of capital. Companies that produce returns
below the cost of capital are not producing sufficient returns on their Assets Prime. In those
cases, that capital would be better used if re-allocated to businesses that can produce superior
As a real ROA’ calculation, the comparable cost of capital for the business is generally around 5.0%
to 6.5% for most companies, depending on the firm’s leverage, size, and a number of economic issues
within the industry and markets in general. Note that this is lower than a traditional Weighted
Average Cost of Capital taught in most schools of thought because most schools leave inflation in
the cost of capital.
The final white bar explains the market’s “hurdle rate” of what is priced-in to the current valuation
of the firm as of the date of the report production. When assessing the firm’s valuation level, the
bar suggests the market’s level of performance expectations for the firm. Changing expectations for
performance above that white bar’s level can generate significant increases in valuation and
therefore, stock price. A low bar is a low hurdle. A high bar is a high hurdle, requiring higher
performance to generate increased valuation levels.
Asset’ Growth stands for “Asset Prime Growth” and is the real annual growth rate of the cleaned-up and
properly adjusted Asset’ base of the company. This metric explains the management team’s propensity to
reinvest over time. When viewed in the context of the ROA’, the growth rate explains a lot about
management’s intended strategies and even performance incentives.
Asset’ Growth is a real metric, meaning it is adjusted for changes in currency levels, generally
inflation. Asset’ Growth can come in the form of organic growth, where a firm simply purchases new
assets through capital expenditures. Asset’ Growth can also come from acquisitions. Negative growth can
come from divestitures, or simply assets aging, leaving the books, without replacement. If a firm shows
capital expenditures that are just enough to replace assets that are aging, the chart should show a zero
Companies that generate an ROA’ above the cost of capital are creating value above the required rate of
return of their Asset’ and should thus be grown. With the exception of start-up firms where longer-term
forecasting horizons are common, companies that display growth when ROA’s are above the cost of capital
generate increased value. If companies do this in excess of what the market expected, the market’s
valuations and stock price will increase. Firms that grow when ROA’s are below the cost of capital will
destroy economic value. If this is done in excess of the market’s forecast for value destruction,
valuations and stock prices go lower. When firms grow at rates of return that match the cost of capital,
no economic value is created. Valuations tend to stagnate.
The final white bar for Asset’ growth in the second panel is a best guess calculation of the expected
growth rate of the firm’s balance sheet, its Asset’ growth rate. This estimate is based on a combination
of management guidance, consensus analyst estimates of growth, and the particular management team and
industry’s growth patterns. The market-implied ROA’ in the first panel is dependent on this growth
estimate and can be adjusted if the growth estimate is believed to be too high or low for whatever
V/A’ is a calculation comparing the value (V) of the company to the Asset Prime (A’). The V is the
market capitalization of the company plus the total debt of the company, including off-balance sheet
debt. The A’ reflects the total Asset Prime of the firm, necessarily adjusted for problematic
accounting standards for reporting of the balance sheet. V/A’ can be thought of as a very
“cleaned-up” Price-to-Book metric. The A’ is the same as the denominator of the ROA’
Throughout the 50+ years of history and across industries and countries, there continues to be a
tremendously strong relationship between ROA’ levels and V/A’. In other words, firms that generate
higher cash flows relative to their investment base experience higher market valuations relative to
their investment base.
The historically strong relationship between valuation levels and firm “quality” – between V/A’ and
ROA’ – creates an opportunity for evaluating valuation levels very quickly. The empirical, observed
relationship between quality and valuation when measured this way is amazingly intuitive and
The market tends to value V/A’ at “1” when the firm generates an ROA’ at the cost of capital. In
other words, firms trade near their “book value” when their returns are merely at their cost of
capital. When the firm’s cash flow returns sustain double the cost of capital, the valuations tend
to be double the book value, and so on. Again, the observation is extremely intuitive and even
somewhat serves as a proof of the necessity for “cleaning-up” the accounting data. Relationships
between traditional Price-to-Book metrics and other return metrics are seldom so logical.
Interestingly, there appears to be a “floor” for valuations, regardless of how negative returns can
go. V/A’ tends to not fall substantially below 0.6 unless there is a risk of credit default or
bankruptcy. When V/A’ is far above the traditional relationship to ROA’, it does not necessarily
suggest overvaluation. It suggests that investors forecast for future ROA’ improvement and growth
could be far higher than traditional firms, such as in earlier growth stages of companies.
Fwd V/E’ is a cleaned up, forward-looking Value-to-Earnings metric. The numerator is the Enterprise
Value of the firm, and therefore the same V from the V/A’ metric. The denominator which is the
adjusted earnings number is the same calculation as in the numerator of the one year forward ROA’
Over the duration of an economic cycle, V/E’ tends to be 15x to 20x, based on the market’s expected
sustainability of the cash flows the company is expected to generate. Start-up firms in early stages
of growth can show extremely high and even negative V/E’ multiples. Companies with extremely “bad
years” of performance can also show such negative V/E’ valuations as the market “sees” through the
near-term problems and attempts to value the firm based on longer-term future cash flow streams. In
both of these cases, the value of deconstructing the V/E’ into V/A’ and ROA’ can be far more
V/E’ is very similar to a traditional V/E in its use. V/E’ is useful on an absolute basis; low V/E’
firms have low expectations of future performance by the market. High V/E’ firms have high
expectations of future performance in terms of growth and returns. One should be careful not to
judge high V/E’ firms as immediately “overvalued” or low V/E’ firms as undervalued. The measure
merely reflects the forecasted future cash flows of the firm relative to the one year forward
The V/E’ can be useful as a relative valuation tool, comparing it against a company’s peers in its
sub-industry, industry, sector, and relative to its historical valuations. If a company is trading
at a substantially lower V/E’ than it has historically, though fundamentals such as ROA’ and Asset’
growth have not changed, the company may be undervalued, and visa versa.
The combination of triangulating three distinctly different valuation models on one chart can be
powerful in understanding the expectations of the market form different perspectives. The
market-implied ROA’ is based on Discounted Cash Flows. The V/A’ is valuable in the context of the
ROA’s of the firm, and the V/E’ can be examined like a traditional P/E would be for comparing
Total Shareholder Returns (TSR) Relative are traditionally known as the capital gains of the stock,
adjusted for any stock splits or similar action, plus dividends, over some period of time. No
adjustments are made to the well-known standard calculation.
TSRr calculates the TSR relative to the performance of the S&P 500 in the USA, or some other major
market index (if it’s more relevant) when examining companies in other countries. If the stock
returns 20% in capital gains and dividends in a year, and the market returns the same 20%, then the
TSR Relative will show the company’s TSR as flat or horizontal in the chart for that year.
When the Relative TSR is above 1x for any given period, the line is sloping upward, and it means that
the company’s TSR has outperformed the market. When the line is sloping downward for any given
period on the chart, the company’s TSR has underperformed the market.
It is very possible that in years where the market shows high returns, the TSRr of the company can
slope downward, and yet have still posted positive stock returns in absolute value – and vice versa.
Firms that continuously “surprise” the market with ROA’s and Asset’ growth rates in excess of the
market’s expectations will see the firm’s TSRr slope upward for that same duration of time. A firm
where expectations were already very high for future ROA’s and growth, and which succeeds in meeting
that expectation, will see the TSRr slope evenly with the market. Meanwhile, a firm with very low
expectations of performance, which simply surprises the market with mediocre performance levels, and
yet still above prior expectations, can see TSRr slope upward precipitously.
Great companies are often not great stocks, and vice versa, depending on expectations.