Good Value Hunting with Coach, Inc. and Amazon.com

I got a bad case of Fractions, and the only prescription is Matt Damon! There is a great scene in Good Will Hunting, where the MIT professor and Matt Damon are doing higher level calculus on the blackboard, and they start canceling out numerators and denominators. The scene gets creepy because of the professor's insistence on putting his arm around Will afterwards like some kind of post-coital cuddle - but the fraction cancelling is really what got me thinking. I swear.

The cool thing (one of the many cool things) about fractions is what happens when you multiply them. As an aside, I saw a bumper sticker yesterday that said "4 out of 3 people have trouble with fractions." That's funny. At any rate, you can simply cancel out the like terms on the top and bottom very quickly to get your answer. Much like this:

In fact, it works with anything in the fractions as long as they cancel out. Here's an example using Robin Williams, Matt Damon, a rusty wrench, and a fancy ladies cowboy boot. Just scratch the rough and tumble counselor and the troubled savant and you get one of the more useful ratios out there:

FB/W (Fashion Boot to Wrench - be on the look out, I'm introducing this tool to the financial markets in an upcoming newsletter)

See, it works - you wind up with FB/W. Return on Equity, or ROE, is also a fraction - defined as Net Income divided by average Equity. Put simply, how much did this business earn on the back of the dollars invested (book value) in the business. High numbers are good. However that's where the simplicity ends. Before WWI, a former explosives salesman and electrical engineer at DuPont (Donaldson Brown) came up with a cool way to break apart ROE into components that would provide further insight into how high or low ROEs are being created. Oddly enough, Mr. Brown resembled a buttoned-up Casey Affleck.

Here's how "Dynamite Don" (as he was known at speakeasy happy hours) broke down ROE:

Coworker at DuPont: "Holy crap, Dynamite! That's a lot of bath tub absinthe, you sure you can handle that?"
Don: "I'll take care of the absinthe drinkin' and the analysis of value creation and you stick to being a whiny little girl."

Looking at ROE this way gives you some insight into how the business is delivering returns. For example, a highly levered business with very little margin and painfully slow asset turnover could deliver high ROEs. Would you like that stock in your portfolio? Dynamite Don didn't care either way; he just wanted to understand what he was dealing with.

So the question becomes, how does basic DuPont analysis help us now? Using a ranking system based on the DuPont formula, we can run a check on who has been achieving high ROEs without the help of leverage. Leverage isn't a bad thing, but it's nice to know who is doing it the ol' fashioned way. Or, we could take a look at who is delivering small margins, slow turnover and high ROEs with the help of high debt.

Coach, Inc. (COH) is near the top of the list of companies using little leverage and blowing out the second two components of Dynamite Don's formula. Ranking by 5-year averages for ROE, Operating Margin, and Turnover, you find yourself the AP Poll of cash register ringing. If you layer on a variable for Capital Expenditures as a percent to Revenue, Coach tops the list. Yep, keep that one in your fashionable handbag. Given the smoking operating cash flow and heavy reinvestment in the business, should we have been surprised by Coach's last earnings explosion? Don wouldn't think so. He'd leverage that motha, have a shot of bourbon, and then screw the French on a land deal in the South Pacific. Boo-ya! On the other side of the coin, are there any S&P stocks with an LY ROE above 30%, LY Operating Margin under 10%, and a Debt/Equity of over 4? Amazon.com (AMZN) fits that bill. Do you like apples? Amazon got chewed up today to the tune of 5.9%+. How do you like those apples?

Sure, this could all be a matter of coincidence, but I'd like to picture Dynamite kicking back at some oak-covered bar with his feet up on the table, smiling about fractions, Robin Williams, and Ben Affleck's terrible attempt at a Southie accent. Dy….No…. Mite, Mr. Brown. Dy…. No…. Mite.

Article written by: Ben Ruddy
Article posted on: September 21st, 2006

Disclaimer: The author does not hold any shares or positions of AMZN or COH at the time this article was posted.