How To Find Float On The Balance Sheet - On Float Part 4
The goal of this blog is to help us all improve as investors and thinkers so we're a little wiser every day. The hope being that our knowledge will continue to compound over time so we'll have huge advantages over other investors in the future.
The aim of today's post is to continue this process by talking about a topic few investors know about. And even fewer understand.
Most people overlook float when evaluating companies because they either don't know what it is. Don't know the power it can have within a business. Or don't know how to evaluate it.
This won't be an issue here.
Press On Research subscribers already know this as I talk a lot about float in many of the issues I've written. But I want to begin talking about it more here because float is one of the most powerful and least understood concepts of business analysis.
Today's post is a continuation of the earlier posts:
Today I'm going to illustrate how to find float on the balance sheet. And show you what float means in terms of the companies margins.
I'm going to do this by showing you float from two different companies I've evaluated and written up for Press On Research subscribers. One is an insurance company. The other isn't.
On Float Part 4
How To Find And Evaluate Float
I've removed the names from both the companies below. If you'd like to know which companies they are and see the full write ups on them you need to subscribe to Press On Research.
Insurance Company Float
When most people think of float they think of insurance companies so this is where we'll start.
Below is the unedited float analysis I did on an insurance company I wrote up for Press On Research subscribers.
All numbers below are in USD $ millions unless noted.
- Financial Assets: Fixed maturity securities of 94.3 + equity securities of 4.9 + trading securities of 0.1 + loans of 1.9 + cash and cash equivalents of 6.8 + accrued investment income of 0.8 + premiums and other receivables of 11.3 + deferred income tax assets of 3.8 = 123.9
- Operating Assets: Deferred policy acquisition costs of 8.5 + PP&E net of 2 + other assets of 13.9 = 24.4
- Total Assets = 148.3
- Equity of 44.9
- Short-term debt of 0.9 and long-term debt of 17.4 = 18.3
- Float: Future policy benefits of 35.2 + policyholder funds of 1.6 + unearned premiums of 29.9 + taxes payable of 0.1 + other liabilities of 18.3 = 85.1
Total liabilities are 103.4
Float/operating assets 85.1/24.4 = 3.49.
Float supports operating assets 3.49 times.
And Float is "free money" because (NAME REMOVED) earns consistent underwriting profits as it’s earned underwriting profits in six of the last nine years.
Pretax profits have changed to underwriting profit below because normal pretax profits mean nothing for insurance companies.
(NAME REMOVED) had an underwriting profit – profit from operations before taxes here – for the full 2015 year of 6.4.
Underwriting profit/total assets = ROA
- 6.4/148.3 = 4.3%
- Compared to a Morningstar ROA of 3.2%
Underwriting Profit/(total assets - float) = levered ROA
If I were to rely only on Morningstar to get estimates for margins (NAME REMOVED) looks below average at only 3.2%.
Yes I know this isn’t an apples to apples comparison. But normal profit metrics mean nothing for insurance companies.
When considering underwriting profit. Its ROA is a still below average 4.3%.
But (NAME REMOVED) float magnifies its ROA higher.
When considering float, its levered ROA goes up to 10.1%. Or 43% higher than what I calculate it’s normal ROA as.
Having a levered ROA of 10.1% isn’t great compared to normal companies I invest in… But for an insurance company this is a great margin.
One of my investment icons the great insurance investor Shelby Davis looked for insurance companies having an ROA above 10% so this meets his threshold.
Another important metric for insurance companies is ROE. Most great insurance companies fall in the 10 – 15% ROE range.
I calculate (NAME REMOVED) ROE – underwriting profits/shareholders equity – as 14.3% not levered by any float. Compared to Morningstar’s ROE estimate of 10.7. This puts (NAME REMOVED) into the great insurance company category. And there’s still more.
I continue on from here detailing this great small insurance company but now let's explain what everything above means.
Why Does Float Magnify Margins?
As talked about in the post Buffett's Alpha Notes - On Float Part 3 float is positive leverage instead of negative leverage like debt. The positive leverage - float - boosted ROA 43% higher than its normal I calculated.
This magnification of margins happens at any company with float. The more float - and profitability - the company operates on and produces the higher margins are magnified.
Let's go back to the April 2016 Press On Research issue this to find out what this means over time for a company operating well.
Float is things like prepaid expenses. Billings in excess of expected earnings. Deferred taxes. Accounts payable. Unearned premiums. And other liabilities that don’t require interest payments.
But they are the farthest thing from “normal” liabilities.
With normal liabilities you have to pay an agreed upon amount within a certain period or your customers and suppliers will stop paying you.
Float are things you won’t have to pay back for a while the company uses in the mean time to grow the business.
Instead of paying this money out now like normal liabilities. Companies can use these “liabilities” to fund current operations.
Float is positive leverage instead of negative leverage like debt and interest payments.
Think of float as the opposite of paying interest on a loan. Instead of paying the bank for the cash you’ve borrowed. The bank pays you interest to use the money you borrowed. And you can use this money to invest.
A nice example is long-term debt versus unpaid premiums. Both liabilities are listed on the balance sheet. But each is far different from a real world perspective.
With long-term debt you get money in exchange for agreeing to pay back a loan at an agreed upon rate for an agreed upon period. If you don’t you can go into bankruptcy and/or go out of business.
With unpaid premiums you get paid a monthly amount from a customer – say for house insurance – and only have to pay back any amount when a disaster occurs.
If your clients don’t make big claims for a long time – or ever over the life of an individual policy – the company keeps using this “liability” to continue investing and growing the business.
Now let’s keep going with this example…
If you own a home with a mortgage you have home insurance in the United States. The ranges of this vary but let’s say you own a home and pay $300 a month towards home insurance costs.
This $300 a month - $3,600 a year or $36,000 after 10 years – goes to the insurance company every month. Year after year even if you never claim any insurance.
The insurance company holds this money on the balance sheet as a liability because the assumption – probability – is you’ll make an insurance claim at some point.
In the mean time the insurance company invests this money to grow assets. This way it makes sure it has enough money to pay claims when it has to.
Now imagine this multiplied by thousands, tens of thousands, hundreds of thousands, or even millions of customers.
If the insurance company produces underwriting profits on top of the float it gets and invests this money well over a long period this money compounds exponentially.
This is how Buffett and Munger grew Berkshire to the giant it is today.
Remember also from Buffett's Alpha On Float Part 3 of this series... The paper found almost all Buffett's excess performance was due to float and the positive leverage powers it has on a company.
This is why float and the positive leverage it produces for the companies using and growing it well over time is so important. It magnifies all margins at a company not just the ones mentioned above. And if a company operates well the internal value of the company compounds exponentially.
If you're a Warren Buffett/Charlie Munger type value investor this is the exact situation you're looking for.
Now let's get to the non insurance company to finish explaining everything.
Non Insurance Company Float
When most people think about float - if they think about it at all - it's when thinking about insurance companies. But non insurance companies have float as well. Remember from the previous post What Is Float? On Float Part 2:
To summarize the above float is anything listed in the liabilities section of its balance sheet you don't pay interest on.
Interest based liabilities - NOT FLOAT - include capital leases, and short and long-term debt.
Most of the time these are the only interest based liabilities on a company's balance sheet. Make sure by checking the off-balance sheet transactions and total obligations notes - if any - in the companies footnotes.
Examples of non interest based liabilities - FLOAT - include prepaid expenses, accounts payable, taxes payable, accrued liabilities, deferred tax liabilities, unearned premiums, etc.
This means any company that has these kinds of liabilities have float. And since most companies have at least small amounts of these liabilities most companies have float.
How much float a company operates on is what affects their margins. Higher amounts of float compared to operating assets means a higher leveraging of margins.
Now let's get to the float analysis of the non insurance company... Again, the following is unedited except for the removal of the company's name.
All numbers below are in millions of dollars unless noted.
- Financial Assets: Cash and cash equivalents of 2.7 + deferred tax assets of 1.9 = 4.6
- Operating Assets: Accounts receivable of 39.1 + Inventories of 12.6 + prepaid expenses of 1.1 + other CA of 0.3 + net PP&E of 73.7 + goodwill of 2.4 + other IA of 0.6 = 129.8
- Total Assets = 134.4
- Equity of 86.2
- Debt of 14.4
- Float = Accounts payable of 13.3 + Taxes Payable of 0.5 + accrued liabilities of 8.9 + other CL of 1.3 + deferred tax liabilities of 1.4 + pensions and other benefits of 8 = 33.1
- Total liabilities 47.5
- Float/operating assets = 33.1/129.8 = 25.5%.
This means (NAME REMOVED) float supports 25.5% of its operating assets.
- Pretax profits/total assets=ROA
- 18.7/134.4= 13.9%
Compared to a Morningstar ROA of 10.1%
- Pretax profits/ (total assets-float) = levered ROA
- 18.7/101.3 = 18.5%
When I evaluated (NAME REMOVED) in 2012 I knew what float was. But not how to calculate and quantify what float meant for a company. So when I began looking at (NAME REMOVED)again in recent weeks I was shocked to see a big chunk of float helping operate and grow the company.
Because I expected a manufacturer to operate more on short and long-term debt than float. But (NAME REMOVED) float is 2.30 times higher than its short and long-term debt.
What this means for you is that (NAME REMOVED) operates and grows in a healthy way.
This is why its book value per share talked about above rose so much in recent years. But this isn’t all operating on float can do for a company… It also magnifies margins as well.
As you can see from the levered ROA calculation above. This is its true ROA when considering float. Float magnifies its ROA by 8.4 percentage points when compared to the “normal” ROA shown on Morningstar.
This will make a gigantic difference in the long-term. How big? Let me show you below using an example…
Let’s say we have one million dollars that compounds at a 10.1% rate every year for 10 years. With no additions the original million dollars will turn into $2.617 million at the end of 10 years. Great of course. But let’s see what an extra 8.4 percentage points every year will do to this same money over time.
Using the same numbers above. Same time frame. But 18.5% compound rate the original one million dollars will turn into $5.460 million at the end of 10 years. The 8.4 percentage point difference over 10 years time means we make an extra $2.843 million. Or more than double what we would earn with only a 10.1% compound rate.
This helps explain why (NAME REMOVED) book value has grown 2.61 times in only six plus years. And this is why I’m not worried about (NAME REMOVED) other “below exceptional” margins talked about above.
Float magnifies all these as well. Not as much as ROA. But by at least a few percentage points each bringing them up to the exceptional level of other Press On Research picks.
Now let's get back to explaining what everything means. Starting with the things I didn't mention above.
The first thing to notice is the huge reversal in the amount of financial assets and operating assets the two companies have. The insurance company had huge amounts of financial assets and few operating assets. And the non insurance company had the inverse.
An insurance companies balance sheet should always look like this.
Non insurance companies vary more but in general they will have more operating assets than financial assets.
Float supporting operating assets is the amount of float that supports the harder assets of a company. The ones regular companies - non insurance and financials - earn profits from in most cases.
Everything likely makes sense in its place of either financial assets or operating assets except goodwill and intangible assets. Why are these included in operating assets and not financial assets?
Intangible assets (IA) is the easier to understand of the two.
Generally IA are things like patents, customers lists, trademarks, and brand names. These have direct effect on the company operations and is why they're included in operating assets.
For goodwill its more murky... Goodwill is a form of intangible assets that occur when a company acquires another and pays above book value for the company. In effect this means the company pays extra in an acquisition for the companies operations so this is why goodwill is included in operating assets.
There are other reasons as well but for simplicity I stuck with the above reasoning.
The amount of float that supports operating assets line is important for all companies. This is because as mentioned above the more float a company has compared to its operating assets the higher margins are magnified.
For companies having a lot of float and financial assets like insurance companies this number can go well over 100%. For most normal companies this number will be below 100%. But as always the higher this number is the better because it magnifies margins the higher it is.
Separating debt and float in the float analysis is a lot easier to do. Any interest bearing liability - short and long-term debt, capital leases - goes into the debt category. All other liabilities go into the float category.
Now lets sum this all up and bring it back to the beginning to explain how this all affects a company's value.
If I've explained everything well enough in the series so far we should understand -
- What float is.
- Why its important.
- How companies can use float as positive leverage.
- How Buffett got so rich using float.
- How to find float on a balance sheet.
- How to evaluate float.
- How float affects a company and its margins.
- And maybe the most important thing - why float affects a company and its margins.
In the next and final chapter of this series we'll go back to the beginning and explain how float affects a company's value alluded to in On Float Part 1.
If you have any questions, concerns, or comments on float up to this point please let me know in the comments section below.
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