Why McLean Equity Research - McLean Equity Research

Why McLean Equity Research

Due Diligence for Equity Investors

Do you have fiduciary responsibilities? As an independent research firm, McLean Equity Research provides you with the tools to give your clients an objectively fair, unique, and robust evaluation of companies you are looking to buy.

We capture a purely objective record of the economic condition of each company we follow. Our mission is to help investors identify the risk-reward between conservative investments and speculative investments, providing you with fiduciary support to your investment decisions.

We specialize in cash flow valuation analysis for public companies. In today's world, most financial data is not designed for equity investors, but for debt investors. Our service helps equity investors value companies based on the underlying free cash flow of the business. McLean Equity Research is specially designed to help equity investors make better-informed decisions about the risk-reward relationship between companies.

Risk and Reward

Our research has shown the common-sense way to achieve this risk-reward tradeoff goal is to invest in companies that make an Owner Earnings. The fundamental premise of our valuation model is based on a company making an Owner Earnings versus an accounting profit. A key difficulty in measuring either definition of profit is in defining costs and expenses. We believe that looking at return on capital minus a charge for the use of the capital produces a much better view of the value of a company. Measuring the real return on capital invested is what Owner Earnings approach seeks to accomplish. (see Do Your Homework for a definition of Owner Earnings)

We rate companies with a positive Owner Earnings number as conservative investment regardless of size. Companies with a negative Owner Earnings number we rate as speculative investments regardless of size. All companies that we rate as a speculative investment are rated as neutral recommendations.

Note: For fiduciaries following the "Prudent Man Rule" we provide a risk profile for every company we follow. Use our service to avoid speculative investments.

Do Your Homework

Everyone agrees on the importance of "doing your homework" before investing in a company. But what does this advice really mean, and how does an investor follow it?

The aim of this service is to answer these questions by providing an advanced overview of financial statement analysis. In the United States, A company that offers its common stock to the public needs to file periodic reports with the Securities and Exchange Commission (SEC). These reports, income statements, cash flow statements and balance sheets paint a picture of the financial health of that company. They are based on Generally Accepted Accounting Principles (GAAP). Sitting on top of this GAAP framework is a growing pile of literally hundreds of accounting standards and thus complexity in the rules is unavoidable. This can lead to unequitable treatment of financial data across companies.

The goal of all companies is to create value for the shareholder. But how is value measured? The metric we use to evaluate the financial health of a company is Owner Earnings. Owner Earnings is based on classic financial theory and is not entirely different from traditional free cash flow measures. The conceptual pillar to support Owner Earnings is the fact that access to equity capital is an expense and not free. The company does not create value until a threshold level of return is generated for the shareholder after the cost of equity capital is deducted. A company can earn an accounting profit (net income) but not necessarily an Owner Earnings.

Owner Earnings boils down a set of adjustments that translate accrual-based earnings (net income) into a cash-based earning. The idea is simple but rigorous, true profit should account for the cost of capital. This is exactly how companies make internal decisions to allocate their own limited resources based on the money generated versus money invested. Successful companies do not make internal decisions on how to allocate their own resource based on net income but rather on an Owner Earnings basis.

Doing your homework means asking yourself "why should I invest in a company that does not create value for its shareholders capital?" Before you invest, use our service to "do your homework".

Accounting Profit vs. Owner Earnings

Accounting profit is also known as net income (or the more popular investment term - earnings) and is one of the most widely watched metrics when evaluating the financial health of a company. It's the profit after various costs are subtracted from total revenue as stipulated by generally accepted accounting principles (GAAP). However, the cost of equity capital is not included in this calculation. Wall Street treats equity capital as free.

The metric we use to evaluate performance is Owner Earnings. Owner Earnings is similar to accounting profit in that it deducts various costs from revenue, but is different because it also includes the cost of equity capital. It's important to recognize that equity capital is not free. In fact, the cost of equity capital varies with the overall sustainability risks of the company. Long-term sustainability is only achievable to those companies making an Owner Earnings.

Simply, accounting profit does not account for all cost and any evaluation based on this method is incomplete. It is common knowledge that net income is easily manipulated by companies to manage earnings. Our research shows that the best way to evaluate the true financial health of a company is by using an Owner Earnings approach. All McLean Equity Research reports and our Best Value Ranking are based on an Owner Earnings methodology.

Margin of Safety

Our stock selection process is based on our version of Peter Lynch's Fair Value principles. Market capitalization is substituted for Enterprise Value and Invested Capital replaces net asset value. EV/IC ratio tells us the value or multiple accorded by investors to each dollar of capital invested in the company. We then compare this multiple to the company's Owner Earnings growth rate. Enterprise Value gives us the aggregate value of a company relative to a company's true profit after all costs including the cost of equity capital.

EV/IC valuation compared to Owner Earnings growth rate gives us a window to see how much investor expectations are built into the stock. We want to buy companies with strong Owner Earnings earning growth at reasonable valuations. As a general guideline, when the EV/IC ratio is too high, it leaves little room for error. It's best to pass on these types of investments.

Another stock selection method is intrinsic value. Intrinsic value is an estimate of the actual value of a company regardless of market value. It includes tangible and intangible factors, plus many variables of illiquid items which are difficult to properly value. Intrinsic value is a more subjective process as there are many different growth and interest rate assumptions made in the calculation of intrinsic value. Either way, the key to any valuation method is to identify value-added results for the shareholders.

The Margin of Safety Principle, popularized by Ben Graham, is the cornerstone of our investing process. Market expectations (EV/IC) are used rather than market price as a point of comparison to calculate our margin of safety. The key to our process is the fact that we do not make projections of any kind. No earnings forecasts, no sales forecasts, no interest rate forecasts, no growth forecasts, and no future projections. We are looking for the best and most profitable (Owner Earnings) companies in today's marketplace.

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