Security Analysis Part V: Analysis of the Income Account. The Earnings Factor in Common-Stock Valuation

“But it is necessary to caution the analyst against overconfidence in the practical utility of his findings. It is always good to know the truth, but it may not always be remembered that the truth that the analyst uncovers is first of all not the whole truth and, secondly, not the immutable truth. The result of his study is only a more nearly correct version of the past. His information may have lost its relevance by the time he acquires it, or in any event by the time the market place is finally ready to respond to it.”

Introduction

Earnings are the main basis on which the market values companies (outside of bubble periods). Simply, a company’s value is supposed to be equal to its earnings per share multiplied by a quality coefficient dependent on business characteristics, dividend record, stability, brand, market temper, etc. In this way earnings are given a weight equal to all other factors combined. In addition, the latter set of factors are generally influenced by the earnings history; increasing the impact of earnings even more!

This is a problem, not least of which because of the ease with which management can manipulate earnings, and the guess work many times involved in determining this number (calculating loss estimates, etc.). The general principle, is that management should be as accurate as possible in reporting historical earnings, even if these then become less useful in the estimation of the future. The task of the security analyst is to begin from management’s numbers and adjust them to fit his best understanding of the business and the near future’s earning power. This can be referred to as the accounting aspect and is the first part of security analysis. The second, the business aspect, relates to how accurate the earnings history will be as a measure of the future. Finally, the valuation aspect refers to what standards should be followed in reasonably valuing shares.

This part of the book can roughly be broken into three. The first discusses the different levers management has to affect earnings and how the analyst should approach them. The second part discusses how the analyst should use and understand the past earnings record in determining the future. The final part regards the impact of the capitalization structure on the value of a company.

Earnings Levers

“You cannot make a quantitative deduction to allow for an unscrupulous management; the only way to deal with such situations is to avoid them.”

The three most important items that require adjustments of the accounting statements are:

• Nonrecurring profits and losses
• Operations of subsidiaries and affiliates
• Reserves

Nonrecurring Losses

Over the short term the analyst should segregate special entries (both positive and negative) from ordinary operating results as he is most interested in the indicated earning power of the business, not its past record. Over the long term though, these should generally be included as their repeated appearance makes them rather ordinary and recurring.

Sales from certain non-recurring assets such as old plant and property or gains from marketable securities should not generally appear in earnings, but rather be credited directly to shareholders equity. A notable exception are businesses such as insurance that obtain a large amount of their income from securities. In this case, the investment returns of any given year should be replaced for that which can be expected from the manager and portfolio over the long run. In this way smoothing out market fluctuations to achieve a better understanding of what can be expected.

‘Nonrecurrent’ losses are one of the places were management is most likely to delude itself as human nature will push them to include real losses in this category. For example, management might be encouraged to book losses during recessions as non-recurrent when this is simply a part of doing business and will recur over a cycle, albeit not every year. Another problem, is management taking large losses by say writing down inventory in a year and thus lowering its future COGS to boost earnings and show growth. Examples of this, are the expensing of costs that should be capitalized such as R&D, moving expenses, customer acquisition costs etc.

One place where these losses should be realistically excluded is idle plant expenses (of course if they are truly idle). Management can always sell these plants, and even if they gave them away they should not be considered a detriment but merely a zero. The exception, is when these money losing plants are necessary for other parts of the business. In this case the cost is as ordinary and recurrent as the electricity bill.

Subsidiaries

Subsidiaries should be consolidated into the accounting statements, not based on accounting technicalities but on the significance of the holding. Pushing money to and from subsidiaries is a trick that unscrupulous companies use to boost their earnings. A great example of this appears in David Einhorn’s book Fooling Some of the People All of the Time in his battle with the Allied Capital fraud.

The most common subsidiary fraud, is to place a multiplier on the value of dividends received from subsidiaries (writing from chapter 33). Especially if management has ‘built up’ a surplus in the subsidiary waiting for a good time to pay the money to the parent company and smooth out its earnings. Another example of subsidiary tricks played by management, is having the parent company make an investment in the subsidiary and then have the subsidiary pay that back as profit.

Depreciation

There are three main complications in using reported depreciation numbers. First, accounting tules may allow the use of a price different than the cost basis, management may not follow accepted principles, accounting provisions may allow certain undesirable treatment from the point of view of the investor.

From an economic standpoint, depreciation should represent the cost true cost of replacing existing equipment. Not simply the identical equipment, but rather that which would be purchased and used today if it were to be replaced. In practice this number is hard to estimate and it is generally simpler to use the depreciation number based off of the original cost.

Many times management will change the depreciation basis of equipment. This is proper as long as the new estimates represent reality and not an attempt at manipulation, and second that this new number is consistently used for calculating earnings. What is improper is writing up the value of PPE but charging this directly to equity not going through earnings.

Analysts should compare companies’ depreciation policies to those of other in their industry and make adjustments in order to have apples to apples numbers. Especially if management is using non-standard policies such as directly expensing certain costs instead of depreciating them over time (understating earnings).

Mining and oil companies have their own special considerations. When considering to invest in one of these, the analyst should value the oil fields or mines at their current value, not at the historical cost basis on the balance sheet. He should then calculate ‘his own’ depreciation number and use that instead of management’s one to calculate earnings. Moreover, depreciation for these companies should be calculated on the basis of production and depletion and not time (i.e. depreciate half if half of oil field is depleted).

Certain intangibles should be amortized by the analyst (though not necessarily for accounting purposes). For example, below market leases have significant value which needs to be accounted for. If not, once that lease is finished new leases will suddenly increase costs. On the other hand, good will should not be amortized (though certain accounting conventions or tax reasons lead to this actually happening). Good will should be carried on the balance sheet and written down if and when it becomes impaired.

Significance of the Earnings Record

“Quantitative data are useful only to the extent that they are supported by a qualitative survey of the enterprise.”

Looking at historical earnings to determine future earnings, is at once the most important and least satisfactory aspect of security analysis. On the one hand it is the best basis we have to go on, on the other time and again it has proven to not be a very useful guide.

A company’s earning power combines a statement of actual earnings, shown over a period of years, with a reasonable expectation that these will continue into the future unless unexpected events take place. Over a period of years this number should become more robust as it is likely to average out over a business cycle and allow a better understanding, under different conditions, of a company’s normalized earnings. An important distinction to be made here, is that of ‘average earnings’ not being simply the arithmetic average of past earnings but rather the earnings likely to be averaged over a full business cycle. Although the intelligent investor should value companies in this way, it is generally not what the market has used, instead it emphasizes current earnings. This should allow the investor significant opportunities where in his consideration current earnings are well below what should be considered normal for a business. As the authors put it, relating to possible changes in intrinsic value over cycles:

“The mistake of the market lies in its assumption that in every case changes of this sort are likely to go farther, or at least to persist, whereas experience shows that such developments are exceptional and that the probabilities favor a swing of the pendulum in the opposite direction.”

As always, we must consider the distinction between ‘investment’ and ‘speculation’. Investment value should be determined on the basis of demonstrated earnings power, and thus investment decisions should not be made on the basis of expected increases in the earnings power. Purchasing above this would be considered a speculative decision, and the analyst should recognize what amount of price he is considering to be the speculative value.

In the case of a sustained down-trend, the analyst of course cannot accept the past a normal earnings. He must conduct a qualitative analysis to understand the origin of this trend and whether it is likely to continue, subside, or even reverse. This is great ground for the analyst, as the markets manic-depressive tendencies make it believe that any down trend is a hopeless situation and value the business as such. In reality there may merely be a reduced opportunity set and stability is likely to follow (albeit at a lower level than the past).

In looking at historical earnings, analysts need to consider losses qualitatively, treating them as purely quantitative can lead to absurdities (such as issuing more shares increasing value). In some businesses losses are truly anomalies in others just part of doing business. The intelligent investor should differentiate between the two and analyze the business accordingly.

On Predicting the Future

“He can be asked to show only that moderate degree of foresight which springs from logic and from experience intelligently pondered.”

The analyst should not try to predict the future (i.e. predict change), instead simply determine whether the past can be expected to be a good indicator of the future and if this is true, (or the downside is protected enough, say from a strong balance sheet) then the analyst should take advantage of market prices that indicate this to not be the case. In a way the analyst is not predicting new conditions but simply that the past will continue, which is easier to do.

This approach to forecasting counts on two advantages over the trend approach. First, investment decisions are being made on the same basis as business one’s. Second, the conservative nature of this reasoning allows for a liberal margin of safety in case of disappointment (for example, strong balance sheet may remain despite continued negative trend). Finally, this approach leads to less confusion between confidence in the future and speculative enthusiasm.

Rejecting the Past Record

Many examples abound about why the trend should not be trusted. Many businesses that rely on one product or service will go through periods where it is fancied and earnings spike (Fitbit). At this point, likely to be a peak, the market will not only be multiplying by an unusually high earnings number (which cannot continue) it will also assign a high multiplier given the trend. Any one who invests at this price will likely face a substantial loss of capital. Another situation arises when a new business emerges and is mostly dominated by a single name. Initially it will make money but as rivals get funded its advantage will diminish and the initial exuberance will lead to loss.

In certain industries past profitable record may be an indication of a poor future. For example, in mining quickly obtaining high quality ore may lead to depletion of the mine making the remaining ore of lower quality and harder to obtain, directly diminishing the prospects of the investment. Moreover certain companies will look nothing like their past. Certain companies may change their main product or service (Apple), or have an important contract expire. In these cases the past record is not any more relevant to the future than the past record of any other company in the same business line. Common situations of this type are:

• Developments in technology that change the low cost producer (mines, oil, etc)
• Contract expiry and deals with the government
• New entrants into the market
• Significant changes in the prices of a commodity

The Earnings Multiple

“This number of times, or multiplier, depends partly on the prevailing psychology and partly on the nature and record of the enterprise.”

The market generally shoots first (sets price) and asks questions later; prices are not careful deliberate computations but the result of human reactions. Given this, the analyst is incapable of passing judgement on stock prices generally. Some functions he may perform are:

• Set up a conservative basis for the investment valuation (not speculative) of common stocks.
• He may point out the importance of the capitalization structure and the source of income and its impact on a stock’s valuation.
• He may find unusual items on the balance sheet that affect the earning picture.

In general, we are interested on normalized earnings over a full cycle, though certain conditions may make the past year a more accurate guide. For example, if business conditions are neither extraordinarily good nor bad, if the company has shown a long term uptrend, if the investor’s study of the industry gives him confidence in its continued growth. Even rarer circumstances allow the analyst to incorporate higher earnings, situations such as the granting of a patent or discovery of a mine.

That being said, “it is the essence of our viewpoint that some moderate upper limit must in every case be placed on the multiplier in order to stay within the bounds of conservative valuation”. Man’s emotional frailty requires rules of this type which may seem absurd from a purely ‘rational’ standpoint, to protect them from the lure and euphoria of bull markets. A seemingly irrational system that works is more reasonable than a seemingly rational one that does not.

The Capitalization Structure and Its Impact

It’s an empirical truth that the capitalization structure of a company can and does affect its market value. The simple rule is:

“The optimum capitalization structure for any enterprise includes senior securities to the extent that they may safely be issued and bought for investment.”

To see why this is the case we need to understand that the market for securities is usually segmented. There are those who wish to assume risk through the purchase of equities and those who desire safety in the form of bonds. Those desiring safety are willing to pay up for this and thus place a higher ‘multiple’ on bonds than they do on stocks. Now, let’s imagine a company fully capitalized on equity. Its stock will now represent both a risky growth component and a stable bond-like component. The bond buyer will be unwilling to buy in as he must assume the growth risk to go with the stability he desires. The growth buyer (seeking this growth) does not have the ‘taste’ for stability and thus is not willing to value this portion at the high multiple the bond buyer would pay but is just interested in the risky side. This will lead to the enterprise being valued below what it would be where the parts segmented out.

The same is true for companies with too much debt. The bonds will no longer be attractive for bond buyers and the equity may prove too risky for equity investors, knowing they can get wiped out if any problems arise at the company. From an ‘investment’ point of view both fixed income and equity investors should avoid these situations.

Nonetheless, highly leveraged companies can provide substantial returns for the equity speculator; especially if he is skilled. In a sense, the equity holder holds a cheap call on the future profits at the expense of bond holders, who take the brunt of the risk without much of the upside. The nonlinearities of leveraged situations make it such that for example a 25% increase in EBIT could lead to a 50% increase in earnings per share.

In practical terms, with appropriate diversification and if the analyst is reasonably successful at selecting companies with satisfactory prospects the speculator should make substantial profits from leveraged companies. Partiality should be shown to companies with large preferred issues over bonds. As suspending the preferred dividend can help weather the storm of bad times whereas mandated interest payments would lead to the equity getting wiped out.

This leverage can arise in different ways. As discussed we can have financial leverage where the equity gains at the expense of the bonds, but there can also be operational leverage.

“The speculative or marginal position may arise from any cause that reduces the percentage of gross available for the common to a subnormal figure and that therefore serves to create a subnormal value for the common stock in relation to the volume of business.”

If the share price is low relative to sales and earnings are close to 0 or negative, small changes in sales can lead to a substantial increase in earnings. These subnormal conditions can be the consequence of rental payments, unusual increases in operating expenses etc.

A similar situation is encountered in commodity producers. Generally, production per dollar of market value will be higher for high cost producers than low cost producers. This is how it should be, given that the low cost producer makes a higher profit from each unit produced. This implies that the high cost producer will be more sensitive to changes in the price of the commodity, and thus would perform better in a bull market for the product.

This is somewhat irrational as there is no guarantee that the increase in the price of the commodity will be permanent; yet this is how the market behaves. The speculator needs to take into account how the market actually behaves, not how it should theoretically behave.

One important aspect to consider is that as the economics of a leveraged company improve the leverage and speculative characteristics decline, reducing the asymmetry of the situation (not unlike with convertible bonds). The speculator then may sell well before the stock fulfills its potential as his original reasons for initiating the position disappear.

Different Income Streams

Security analysis is particularly useful for issues that receive income from different unrelated assets. The market will tend to price these issues based on the characteristics of the ‘headline’ business without taking a deeper look at the composition. For example, a boring business where earnings are valued at a multiple of 10 could receive a substantial amount of cashflow from safe bonds. The market will generally apply that same multiple to those interest payments received despite the bond being actually priced on the open market at a multiple of 20 (yield of 5% versus 10%). In effect the market would valuing the bonds at half their market value. These situations tend to be rectified by shareholders agitating for management to sell the securities and return the cash to owners.