The Earnings Power 10-Minute Test

Here we go.

Positive book value. We start with the balance sheet. Assets total $1.278 billion, and there are $670 million of liabilities, so corporate net worth (stockholders' equity) is $608 million. Positive book value is a good thing, because it means the company has been profitable over the years. So far, so good.
Debt less than 50% of equity. Performance Foods employs $272 million of interest-bearing debt, almost all of it long-term debt. Divide that borrowed money by $608 million of stockholders' equity, and you get a debt-to-equity ratio of 45%. I'm happy as long as this ratio is below 50%.
Robust sales and earnings growth. Now we size up the income statement. The five-year compound annual growth rates in sales and accrual profits (i.e., net income) are a hearty 22% and 25%, respectively. The two-year growth rates are both 25%. Things look promising.
Defensive profit. Now we shine a light on the statement of cash flow. An easy way to determine whether a firm earns a defensive profit is to subtract the $423 million of cash used in investing activities from the $165 million of cash provided by operating activities. The loss: $258 million.



Included in investing activities is $395 million of net cash for acquisitions, mostly for salad maker Fresh International. While I realize that acquisitions pave the way for higher future sales and earnings, they are also a use of cash. Also, various studies show that more than 80% of all deals don't create value. The green light on this company just turned yellow.

Goodwill and other intangibles. Looking at the amount paid for Fresh International, I'm betting the asset side of the balance sheet contains a slug of goodwill -- a low-quality asset that, unlike receivables, inventory or fixed capital, can't be weighed, touched or measured. In fact, Performance Foods has $604 million of intangibles, which means, among other things, that tangible book value is $4 million.



For a company with $3.2 billion of revenue, $4 million of tangible book is a pittance. And the yellow light? It's now red.

Return on capital. I've pretty much decided Performance Foods doesn't warrant additional research. There is, however, one more ratio: return on capital. If a company has a high ROC -- my absolute minimum is 15% -- then it probably has an enterprising profit.

So how does Performance Foods measure up? In 2001, it recorded $76 million of earnings before interest and taxes on $881 million of interest-bearing debt and stockholders' equity. Its pretax return on capital, therefore, is 9%, which means its after-tax return is in the mid-single digits.

I wanted to like this company, believe me. But defensive losses, practically zilch tangible book value and a subpar return on capital are deal-breakers, despite the sharp gains in sales and accrual profits.

Of course, more important than what I think of Performance Foods is whether you have a strategy that allows you to spend the bulk of your time on the most promising investment opportunities. Therefore, consider adding the Earnings Power 10-Minute Test to your approach. It will improve your analytical skills and also give you more free time for the really important things in life.

Thanks to reader W.G. of Richmond, Va., who suggested that I look at Performance Foods.

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A note to readers: Many of you have asked how my book is coming along, and I'm pleased to announce that McGraw-Hill will be my publisher. The manuscript is due March 1, and we hope it will be in bookstores by late fall.

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Hewitt Heiserman has been a financial analyst for 15 years and has worked for Fidelity Investments, Simplex Time Recorder, American Holdco and Breakaway Solutions. He is now writing a book on the Earnings Power Box, an analytical model he created to gauge the quality of a firm's profits. (The Earnings Power Box is a trademark of Hewitt Heiserman.) At the time of publication, Heiserman had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback and invites you to send it to [e-mail].