Earnings Power Valuation Model

Earnings Power Valuation Model

Hewitt Heiserman Jr., EarningsPower.com

I. Common Stocks and Earnings Power:

All investors share a common aspiration: to own a stock that makes a difference. After all, just think what your life would be like today if you bought $10,000 worth of Paychex, Inc. (PAYX:Nasdaq) at the beginning of 1990. Imagine you still owned these same shares of the payroll-services provider at the end of 1999, and they’re worth $350,000. Imagine indeed.

So how do you find your own Paychex?

There are, of course, many ways to prosper handsomely on Wall Street (just as there are many ways to lose money in the stock market). Some venerable investment strategies are net-net, sum-of-the-parts, turnaround, spin-off, cyclical, short-selling and merger arbitrage.

Perhaps the most popular investment strategy, though, is to buy shares of a growth, or "earnings power," company. According to conventional wisdom, an earnings power company is a company whose earnings steadily rise over many years.

Paychex is an earnings power company. During the 1990s, its per-share earnings increased to 37 cents from 3 cents. Meanwhile, its stock rose to $18.67 from a split-adjusted $0.62.

Of all the companies in the stock market, earnings power companies are the most glorious. Indeed, firms with long skeins of earnings growth are the corporate equivalents of Botticelli’s "The Birth of Venus" or Goddard-Townsend Chippendale mahogany block-and-shell-carved secretaries -- objects of extraordinary achievement that every investor should study intently. Depending on the number of shares you buy and when, the capital gains from a stock that performs even fractionally as well as Paychex can help you buy a home, pay for a child’s college education, care for a loved one, retire a few years early where it's always sunny or make a generous bequest to a charitable institution.

Extraordinary Achievement: Paychex, Inc.
Year / EPS / Stock
1990 / $0.03 / $0.62
1991 / $0.03 / $0.93
1992 / $0.04 / $1.48
1993 / $0.06 / $2.36
1994 / $0.08 / $2.70
1995 / $0.11 / $4.18
1996 / $0.15 / $9.04
1997 / $0.20 / $11.13
1998 / $0.27 / $16.67
1999 / $0.37 / $18.67
Source: Company reports, BigCharts.com. Stock prices as of fiscal year ending 5/31

Still, this strategy is not without risk. Here are three reasons:

First, it’s human nature to let your guard down when a firm’s stock price keeps going up and up.

Second, even the bluest of blue-chip stocks can sear a hole in your wallet if you overpay (which, admittedly, is always more obvious in hindsight).

Third, just because a company keeps making more and more money every year does not mean that it possesses authentic earnings power. This is because the accrual income statement in every annual report, 10-K and 10-Q has four substantive limitations: (1) It omits investment in fixed capital, (2) it omits investment in working capital, (3) it expenses intangible growth-producing initiatives, and (4) shareholders’ equity is free. As a result, one person’s profit is another’s loss.

II. Four Substantive Limitations:

Here are brief remarks on the four substantive limitations of the accrual income statement in every annual report, 10-K and 10-Q:

1. It omits investment in fixed capital. A company makes an investment in fixed capital when its capital spending is greater than depreciation. The accrual P&L omits investment in fixed capital because plant, property and equipment are expected to have useful lives beyond the period in which they are acquired. To fully expense the costs of warehouses, lathes or a fleet of trucks would contradict one of the bulwarks of accrual accounting -- that current sales are matched with current expenses and future sales are matched with future expenses.
2. It omits investment in working capital. Working capital assets are accounts receivable, inventory and prepaid assets, and working capital liabilities are accounts payable and accrued expenses. The difference between the two is net working capital -- working capital for short. When working capital increases from one period to the next, a company is said to have made an investment in working capital. This use of cash is omitted from the accrual income statement because it is not an operating expense.
3. Intangible growth-producing initiatives are expensed when incurred. Intangibles covers things like research and development, marketing and advertising and employee education. Intangibles are immediately expensed because they are a cost of business.
4. Shareholders’ equity is free. All companies are financed, or "capitalized," with a mix of debt and equity. Debt capital bears an explicit and legally contracted rate of interest, and is an expense in the accrual income statement. In contrast, there is no line item for the cost of equity capital. That’s because companies are not required to pay their owners any particular rate of return.

As a result of these limitations, a company may appear profitable in the traditional (i.e., accrual) sense of the word even though it’s unable to self-fund and/or create value. A company is able to self-fund when it produces more cash from ongoing operations than it consumes. It creates value when it produces a return on capital that is greater than its cost.

What Are ‘Accrual Profits’?
We refer to the income statement found in all public companies’ financial statements as the accrual income statement. The prefix ‘accrual’ is used for two reasons: first, when accountants prepare a firm’s financial statement they follow the rules of accrual accounting; and second, the term distinguishes it from the defensive and enterprising income statements (see Section III, Opposing Personality Types). Accrual profits, then, are the same thing as net income as determined by generally accepted accounting principles.

III. Opposing Personalities:

In The Intelligent Investor, (1973) Benjamin Graham describes two types of investors: defensive and enterprising. The chief aim of the defensive investor, Graham explains, is to avoid committing "serious mistakes or losses." In contrast, the primary goal of the enterprising investor is to own companies "more attractive than average." To put it in vocational terms, the defensive investor emphasizes "safety first" like a commercial banker, while the enterprising investor thinks in terms of growth for tomorrow, like a venture capitalist.

Ideally, the accrual income statement would accommodate both defensive and enterprising investor. Unfortunately, however, the income statement in every annual report, 10-K and 10-Q is often poorly suited to meeting the needs of either personality type. This can cost you money or waste your time.

From the defensive investor’s perspective, the problems with the accrual income statement are its omissions of investment in fixed and working capital. This is because they are uses of cash. Every dollar invested in fixed and working capital is a dollar less that can pay interest, reduce debt, repurchase stock or boost the dividend. As a result, a firm may appear profitable even though it’s unable to self-fund. Companies that can’t self-fund eventually go bankrupt.

To identify companies that can self-fund, the defensive investor turns to the "defensive" income statement. The defensive P&L expenses investment in fixed and working capital immediately. If a company makes money after these two adjustments, then it is has made a defensive profit. Companies with defensive profits are able to self-fund and finance their growth with internally generated free cash flow, while companies with defensive losses are at risk of running out of money. (Intangibles are immediately expensed because they are uses of cash. As for shareholders’ equity, it is free because it is a noncash cost.)

Meanwhile, from the enterprising investor’s perspective, the problems with the accrual income statement are that intangible growth-producing initiatives are expensed in the year incurred, and that shareholders’ equity is "free." Expensing intangibles penalizes forward-thinking companies that are laying the foundation for higher future sales and earnings. As for shareholders’ equity, because no charge is recorded for its use a company may appear more profitable than perhaps it really is.

To remedy these deficiencies, the enterprising investor turns to the "enterprising" income statement. The enterprising P&L converts intangibles from operating expenses to capital assets, thus enabling apples-to-apples comparisons of hard-asset companies with soft-asset firms in, for example, drugs, software and technology. As for shareholders’ equity, it is expensed, typically at a minimum rate of 10%. If a company makes money after these adjustments, then it has made an enterprising profit. Companies with enterprising profits create value and make good use of their owners’ time, while companies with enterprising losses destroy value and squander wealth. (Investments in fixed and working capital are not expensed, at least directly, because they are expected to produce higher future sales and earnings. That’s why they’re called investments.)

Comparison of the Defensive and Enterprising Investor
Personality / Commercial banker / Venture capitalist
Objective / Make sure company can self-fund, because companies that can’t may go bankrupt and cost you money / Check whether company is creating value, because companies that can’t waste owners’ time and may cost you time
Income statement / Defensive / Enterprising
Four (4) limitationsof the accrual income statement / #1. Investment in fixed capital / Expenses when incurred / Not applicable
#2. Investment in working capital / Expenses when incurred / Not applicable
#3. Intangibles are expensed when incurred / Expenses when incurred / Capitalizes on the balance sheet as an asset and then depreciates over an appropriate period
#4. Shareholders’ equity is free / Not applicable / Expenses at the firm’s estimated cost of capital
Key assumptions / What part of capital spending is growth capex? / Cost of equity; depreciation period for intangibles

IV. The Earnings Power Box :

A proposition: A company has authentic earnings power when it is profitable the way both defensive and enterprising investor thinks about profits. Thus,

Asking whether one alternate income statement is "better" than the other is like asking whether your car’s gas pedal is more important than the brake. They are both important, but for different reasons. The defensive income statement tells you whether a company can self-fund; the enterprising income statement reveals whether the business is creating value.

This is key: A company may be able to self-fund but not create value, or create value but not self-fund. The two are not the same, and both are essential to having authentic earnings power.

To illustrate, let’s examine Paychex, Lucent (LU:NYSE), Enron (ENRNQ:OTC BB) and Bethlehem Steel (BHMPQ:OTC BB). Each company had accrual profits for the specified period (see below, Quality of Profits chart). Crucially, however, only Paychex had authentic earnings power; i.e., it was profitable the way defensive and enterprising investors think about profits. Meanwhile, Lucent had a defensive loss, Enron had a defensive and enterprising loss, and Bethlehem Steel had an enterprising loss. Thus, the quality of accrual profits for these three companies were suspect.

We recognize the need for using the defensive and enterprising income statements to gauge the quality of a firm’s accrual profits. Using an x-y scatter chart, we can recast these two alternate P&L's in picture form, so you can effectively visualize the information. The scatter chart shows us what the accrual ledger often obscures: whether a company meets our two condition precedents of authentic earnings power, namely, the ability to (1) self-fund, which is assessed by the defensive income statement, and (2) create value, which is assessed by the enterprising income statement. Enterprising profit (loss) is plotted on the x (horizontal) axis, defensive profit (loss) goes on the y (vertical axis).

As you would expect, the best companies to own are those situated in the upper-right, or "earnings power," box. This is the long-term cautiously greedy investors' Valhalla -- their investment center of gravity. Companies in the Earnings Power Box (EPB) offer the prospect of ample capital gains while also letting you sleep peacefully at night.

The worst companies are situated in the lower-left box, even if they are profitable in the accrual sense of the word. If you own a LLB company, then kiss it goodbye fast. (The exception to this rule is that the firm’s valuation is compelling and you believe it is in the midst of a successful turnaround.)

Businesses in the upper-left box are self-funding but not creating value, while firms in the lower-right box are creating value but not self-funding.

As we see, although each of our four companies was profitable on an accrual basis, Paychex was the only company situated in the EPB.

At the other end of the spectrum is Enron. Although the energy trader made money in the traditional sense of the word, it was lost money the way defensive and enterprising investors think about profits. Contrast what this model reveals about Enron’s 2000 performance with these breezy sentences from its annual report:

Enron’s performance in 2000 was a success by any measure . . . The company’s net income reached a record in 2000. Enron is laser-focused on earnings per share, and we expect to continue strong earnings performance.

To be sure, not every company in the EPB will become a gold mine like Paychex, nor will every business in the LRB, LLB and ULB become sinkholes like Lucent, Enron and Bethlehem Steel. Still, unless you're as rich as Croesus, doesn’t it make sense to put your hard-earned funds on the highest-probability bets, especially if you intend to own the company for the long haul?

If a company you own is not in the EPB, find out why. That’s because the other three boxes are "pain" boxes. The model is telling you that something is wrong with the business, or at least it’s not as profitable as it should be. Maybe the company is slow to collect its receivables. Maybe its warehouses are stuffed to the roofs with inventory that won’t sell. Maybe the company is in the midst of an aggressive capital spending program (which may or may not succeed!). Or maybe it’s just not profitable enough in relation to all the capital that’s been invested in the business.

V. Methodology:

Companies do not tell you whether they are situated in the Earnings Power Box . Therefore, we must build a defensive and enterprising income statement ourselves. Proceed as follows:

1. Obtain a firm’s annual report or 10-K for the last several years.
2. Use key data from the income statement, balance sheet, statement of cash flows and footnotes to build our two alternate P&L’s.
3. Plot enterprising profit (loss) on the (x) horizontal axis, and defensive profit (loss) on the y (vertical) axis. The intersection of these two points will be in one of four boxes. The best companies (but not always the best stocks) are situated in the upper-right, or "earnings power," box.

To illustrate, let’s return to Paychex. As calculated below, Paychex’s accrual, defensive and enterprising profits for the year ended May 31, 1999 were $0.37, $0.35 and $0.32, respectively. Each of the accrual income statement’s four substantive limitations is highlighted in bold letters.

3 Types of Profits: Paychex, Inc. For the fiscal year ending May 31, 1999.(Thousands except per-share)
Income Statement / Accrual / Defensive / Enterprising
Revenue
Cost of goods sold
SG&A
Other expenses (income) (a)
Investment fixed capital
Investment working capital
Intangibles
Total operating expenses
Earnings before interest and taxes
Interest expense (b)
Pre-tax profits
Taxes
Other expenses (income)
Profit
Per-share (373,182 diluted shares) / $1,175,428
730,088
257,778
(12,581)
n/a
n/a
0
975,285
200,143
0
200,143
61,044
0
$139,099
$0.37 / $1,175,428
730,088
257,778
(10,814)
7
6,417
0
983,476
181,138
0
191,952
61,783
0
$130,169
$0.35 / $1,175,428
730,088
257,778
(200)
n/a
n/a
0
987,666
187,762
11,091
176,671
59,089
0
$117,582
$0.32
Source: Company reports, EarningsPower.com

(a) Accrual includes $12,581 of investment income. Defensive includes $10,814 for amortization other intangibles. Enterprising includes a $200 increase in current deferred credits.

(b) Enterprising interest equals the firm’s estimated weighted average cost of capital times average capital for two years. Capital is the sum of the book (i.e., accrual) value of interest-bearing debt, preferred stock and shareholders’ equity, as well as deferred taxes, capitalized operating leases, reserves, net capitalized intangibles, cumulative goodwill amortization, unrecorded goodwill, cumulative unusual (gains) losses A/T, cumulative extraordinary (gains) losses A/T and (non-operating cash and marketable securities).

By combining results from Paychex’s 1999 performance with earlier years we can examine earnings quality for the entire decade. It’s a remarkable chart, as evidenced by the close proximity of defensive and enterprising profits to accrual profits. This is the chart of a company with high-quality, or profitable, growth.

The hallmark of extraordinary corporate achievement is the Earnings Power Staircase, so-named because when defensive and enterprising profits steadily rise over time the x-y scatter chart looks like the profile of a staircase. (In this analogy the rise is the incremental increase in defensive profits, while the run is the periodic change in enterprising profits.)

As depicted below, Paychex had a Staircase during the 1990s, which helps explain why the stock appreciated 2,911%. Not only was the firm situated in the EPB during most of the decade, but it kept moving in an upper-right direction.