Our method: from earnings quality to what the price discounts
Five filters we will apply to every company: unit economics, earnings quality, return on capital, capital allocation and reverse valuation. And one rule: every thesis is born with the conditions that would invalidate it.
By Daniel Cánovas Durán · 4 min read
Almost any company looks good when read from its earnings release. Earnings per share rise, adjusted EBITDA improves and management talks about "profitable growth". An analyst's job is to check how much of that is cash, how much is accounting and how much is already in the price.
These are the five filters we will apply, in this order, to every company at Rincón Monetario.
1. Unit economics: what does it earn on each sale?
Before looking at the aggregate, we take apart one unit of the business: a customer, an order, a store, a contract. Acquisition cost against contribution margin, renewal rate, pricing power. If the unit economics don't work, growth only multiplies the problem.
The underlying question is competitive advantage: what stops a competitor from replicating those margins. Switching costs, network effects, scale or brand. If we cannot name it precisely, we assume it doesn't exist and that margins will revert to the industry average.
2. Earnings quality: how much of it is cash?
Net income is an opinion; cash is a fact. We measure cash conversion: free cash flow over net income, across several years so as not to mistake the working-capital cycle for deterioration.
| Signal | What we look at | Red flag if… |
|---|---|---|
| Cash conversion | FCF / net income, 3–5 year average | Persistently below 80% |
| Accruals | (Net income − operating cash flow) / total assets | Positive and rising |
| Working capital | Days sales outstanding, inventory and payables | Receivables and inventory stretch faster than sales |
| Capitalised costs | R&D or software capitalised versus expensed | Capitalised amounts grow faster than expenses |
| Adjustments | Adjusted EBITDA versus reported EBITDA | The gap recurs year after year |
| Stock-based compensation | Cost versus FCF | Excluded from "adjusted" but dilutes shareholders |
3. Return on capital: does it create value or just grow?
The core indicator is ROIC: operating profit after tax (NOPAT) divided by invested capital (equity plus net financial debt, or equivalently operating fixed assets plus operating working capital). A company only creates value when its ROIC exceeds its cost of capital (WACC). Growing with a ROIC below WACC destroys value, however fast the growth.
Fictional company, for illustration only. With an 8.5% WACC, by year 5 every euro reinvested destroys value.
More than the level, we care about incremental ROIC: the additional operating profit generated by each euro of new capital. A high but falling ROIC, as in the example, usually means the best reinvestment opportunities have already been used up.
4. Capital allocation: what does management do with the cash?
Cash generated has only five destinations: reinvest in the business, acquire other companies, pay down debt, pay dividends or buy back shares. We assess each against its alternative:
- Acquisitions: price paid (EV/EBIT multiple), accumulated goodwill and later impairments. A history of impairments is an admission of overpaying.
- Buybacks: they only create value if done below intrinsic value. We compare the average buyback price with the share price and with dilution from share plans.
- Debt: beyond net debt / EBITDA, we look at interest cover (EBIT / interest expense), the maturity schedule and the share at floating rates. With Euribor above 3%, refinancing matters.
Management pay says a lot: incentives tied to EPS or adjusted EBITDA push for growth at any price; incentives tied to ROIC or cash flow per share align interests with shareholders.
5. Reverse valuation: what does the price discount?
Instead of building a DCF with ten assumptions and presenting a "target price" with false precision, we start from the market price and ask what growth and margins you have to believe for it to be justified. If the price only holds up with growth the company has never achieved, that is where the risk lies, however good the company.
We complement it with three references:
| Metric | What it answers |
|---|---|
| EV / EBIT | How much is paid for operating profit, debt included |
| FCF yield (FCF / market cap) | What cash return the shareholder gets today, comparable with the 10-year bond yield |
| Multiples versus its own history and its sector | Whether the valuation is exceptional or usual for this company |
The final rule: every thesis is born with its exit condition
Every investment thesis published at Rincón Monetario will include, besides the idea and the risks, the specific conditions that would invalidate it: for example, cash conversion falling below 70% two years in a row, or incremental ROIC dropping below the cost of capital. Writing them down beforehand prevents reinterpreting the data later in order to be right.
Theses will be reviewed over time, using the publication price as the reference, whether they turn out right or not. That record is the only honest way to measure whether a method works.
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