Analyzing Growth in Firm Value

We’re nearing the end of second quarter earnings season, and I have have had my share of hits and misses, compared to the estimates that the sell side publishes.  What is the sell side?  The sell side is the analysts working for broker-dealers who publish research on companies, often estimating what they think they should earn in a quarter or year.  There is a buy side as well, which are analysts working for mutual funds, asset managers, etc., who analyze companies for their employers.

As investors, we are pelted with terms for corporate performance:

  • Comprehensive income — increase in net worth (approximately)
  • EBITDA  (Earnings before interest, taxes, depreciation and amortization) — what monies are the assets of the company generating in cash terms
  • Operating income — Net income, excluding one-time charges.
  • Net income — An attempt to show the repeatable increase in the value of the business, excluding the adjustments that operating income makes.  It also excludes “temporary differences” that are expected to reverse, which go into Accumulated Other Comprehensive Income on the balance sheet, and not through income.  An example would be unrealized capital losses on unimpaired credit instruments.

Which of these measurements should an investor use?

  • In takeovers, EBITDA is the most relevant, because it shows the cash generating capacity of the assets.
  • Operating income is the most relevant each quarter for companies that are going concerns.  It excludes “one time” events.
  • Over the long haul, accumulated net or comprehensive income is the most relevant, because all of the “one time” adjustments are aggregated.

In the short run, the adjustments that come from one-time events (mostly negative) can be tolerated.  But managements are supposed to try to control the factors that generate one-time events in the long run.  That part of their job.  If you have enough track record on a management team, you can sit down and calculate accumulated operating income less accumulated net income.  For good managements, that number is negative to a small positive.  For bad managements, it is a big positive.  I’ve seen estimates over a long-ish period of time, and the average difference between the two is around +5% — +10%.  That much typically goes up in smoke from operating earnings, never to reappear.

Now, some have toyed with adjusted dividend yield formulas, where they add back buybacks, and they use that as a type of true earnings yield.  After all, that reflects cash out the door for the benefit of shareholders.  True as far as it goes, but other uses of retained earnings aside from buybacks are valuable as well.

  • Buy/create a new technology, plant or equipment
  • Buy/create a new product line
  • Buy a competitor, or, a new firm that offers synergies
  • Buy/create a new marketing channel

In the hands of a good management team, these actions have value.  In the hands of bad management teams, little value to negative value.  So, I prefer earnings to these new measures based off dividends and buybacks for good management teams.  With a bad management team you want them to not have much spare capital for bad decisions, but would you trust the safety of the dividend and commitment to the buyback to a bad management team?  So, in general I prefer earnings, or, if calculable, free cash flow, to dividend/buyback metrics.

What is free cash flow?  The free cash flow of a business is not the same as its earnings. Free cash flow is the amount of money that can be removed from a company at the end of an accounting period and still leave it as capable of generating profits as it was at the beginning of the accounting period. Sometimes this is approximated by cash flow from operations less maintenance capital expenditures, but maintenance capex is not a disclosed item, and changes in working capital can reflect a need to invest in inventories in order to grow the business, not merely maintain it.

Ideally, free cash flow generation is what we shoot for, but it is difficult to estimate in practice.  When I took the CFA exams, the accounting text suggested that the goal of earnings was to reflect free cash flow to the greatest extent possible.  I’m not holding my breath here; I don’t think that goal is achieved or achievable.  To do that, we would have to have managers expense maintenance capex, and we would have to reflect the capital requirements of financial regulators as a cost of doing business for financial companies, and there are many more adjustments like those.

So, I like accumulated net income in the long run and operating earnings in the short run for measuring financial performance.  I’ll give you one more measure to consider which might be better.  From a not-so-recent CC post (point 2, rest snipped for relevance sake):

David Merkel
Notes Before I Leave for ANother Series of Conferences
11/9/04 5:44 PM ET
1. Be sure and read Howard’s piece “Hurricanes and the Limits of Rebuilding .” He comments more extensively on something I touched on when Frances was threatening Florida. Recovery from disasters often makes GDP look better afterward, because the destruction is not captured in the GDP statistics as a loss, save for the reduction in insurance profits, whereas the work of rebuilding does get fully captured.

2. The same idea can be applied to equity investing. This is why I pay attention to growth in book value per share, ex accumulated other comprehensive income, plus dividends, rather than earnings. Nonrecurring writedowns, charges for changes in accounting principles, and other adjustments, if they happen often enough, it makes a statement about the way a company handles accounting. Companies that are liberal in their accounting may have good looking earnings, but growth in book value per share can be quite poor. I trust the latter measure.

Growth in fully diluted tangible book value (ex-AOCI) is a good measure of firm performance, if you add back dividends, and subtract out net equity issuance/buyback measured not at cost, but at the current market price. Why the current market price?  Some managements buy back stock indiscriminately, not caring about the price at purchase.  That’s rarely a good idea.  Good management teams wait until their shares are near or below their estimate of fair value before they buy back.

Good management teams are also sparing/judicious with share and option grants.  Measuring the cost of the issuance/grants/dilution at the current market price penalizes the financial performance appropriately for what they have given away from shareholders equity per share all too cheaply.

So, that’s my preferred measure for how much has the underlying value of the firm increased: growth in fully diluted tangible book value (ex-AOCI), adding back dividends, and subtract out net equity issuance/buyback measured not at cost, but at the current market price.

There are things that this measure does not capture, though.  Look for places where assets are misstated on the balance sheet. E.g., property may be worth more or less than the carrying value.  Plant and equipment may be worth more or less than the carrying value.  Having a feel for the appreciation/depreciation in value, however slow, can be an aid to estimating the true change in value for a firm.

Estimating the true value of a firm’s earnings is challenging.  There is no one good measure; it depends on the question that you are trying to answer.  But knowing the outlines of of the problem helps in analyzing the earnings releases as they pelt us each quarter.

PS — I know I have excluded EVA, NOPAT, and other measures here.  Perhaps another day…