The Anatomy of Earnings

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”- Warren Buffett.

It is always helpful to focus on what a share actually represents- it is a claim on a stream of long term cash flows to which shareholders are entitled over time. Given that the price one pays has a strong relationship with future returns, (the higher price one pays, the lower the expected return will be), a method of valuing these cash-flows would seem a sensible starting point. The future being what it is, however, it is not an exact science. Whether it is by design or malice, analysts often get their projections badly wrong. One of the reasons may be to do with their methods of analysis, or more precisely their mindsets when doing said calculations.

With the above quote in mind, it may be worthwhile to look at some of the metrics used by Analysts to “value” shares, together with some context. You may read some of these bandied about in the FT (among other esteemed journals); clients may even ask about some of them. It may be helpful to know what they mean (and what they don’t mean). This is by no means an exhaustive list, as the industry churn out new valuation standards all the time, in order to generate interest/sales etc. Below is a list of some of the current metrics du jour.

Enterprise Value: A measure of a company’s value, often used as an alternative to straightforward market capitalisation. Enterprise value is calculated as market cap plus debt, minority interest and preferred shares, minus total cash and cash equivalents.

This metric represents the cost of buying the company outright; but it does not equate to ” Value” since it excludes cash (which is surely an asset?) [1]. It is an attempt to equalise different companies that have different capital structures, but it is difficult to accurately measure, and thus compare them, when debt is not freely traded, or where unfunded Pension liabilities exist which are of necessity estimates.

 

Quick Ratio: The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.

This would only be relevant in extreme cases- in a crisis, a company may find it needs to liquidate assets quickly, and this gives an indication of whether it could do so. In truth however, as the Lehman Brothers Balance Sheet from 2008 shows (page 5), even a large amount of cash is no defence if confidence in the solvency of the firm collapses. So this is of limited use in avoiding investment disaster.

 

Working Capital: Working capital is a measure of both a company’s efficiency and its short-term financial health. Working capital is calculated as: working capital = current assets – current liabilities.

As with the above, it depends crucially on what the assets and liabilities are; if the assets cannot be sold at current market valuations, the company may not be able to cover the liabilities, even assuming that the liabilities are visible. ENRON used Special Purpose Entities assiduously to hide debts, making it difficult for investors to see the true nature of the problems until it was too late.

 

Trailing Free Cash Flow: A company’s free cash flow for the previous 12 months. Trailing FCF is used by investment analysts in calculating a company’s free cash flow yield. Trailing FCF is important to investors because it shows how much money a company has brought in over the last year, after subtracting capital expenditures (in contrast to the EBITDA measurement below).

Dividends can only be (sustainably) paid out of free cash flow, so this is a useful measure, but this can be manipulated; delaying accounts payable and advancing accounts receivable can flatter the figures, so caution needs to be taken in interpreting the resulting figure. Of course, companies that have high Capital Expenditure commitments will not fare so well under this metric, and delaying needed Capex is a standard method for improving this number. But in general, rising free cash flow is always better than a falling variety !

 

EBITDA Margin: A measurement of a company’s operating profitability. It is equal to Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA) divided by total revenue. Because EBITDA excludes depreciation and amortization, EBITDA margin can provide an investor with a “cleaner” view of a company’s core profitability.

The problem here is obvious- show me a firm that has no debt (so no I) , doesn’t pay taxes (no T), and doesn’t have any Capital Expenditures (so no D or A), and I would invest in it. All of these are a cost of doing business, and to pretend otherwise is misleading; some cynics (of whom I am not one of course), have referred to this as “Earnings before Bad Stuff”, and it is heavily pushed by Corporate Management (for obvious reasons), as well as Analysts. This pdf delves into the analytical short-comings of using EBITDA, but Warren Buffet probably expressed it more succinctly;

“Every dime of depreciation expense we report (at Berkshire Hathaway) is a real cost. And that’s true at almost all other companies as well. When Wall Streeters tout EBITDA as a valuation guide, button your wallet”.

 

 

 

Finally, a really important one, though not related to earnings per se;

Efficient Frontier: A set of optimal portfolios (or assets), that offers the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal, because they do not provide enough return for the level of risk, or too high a risk for a given level of expected return. This is pivotal to understanding of portfolio construction. By using historical returns and correlation data, we can create a set of optimum assets which have the above characteristics; risk inefficient portfolios will always under perform their well-constructed brethren- lagging in rallies and falling further (or for longer) in corrections, as they are subject to stock-specific risks (for example), that well-diversified portfolios are not. Being over-weight in one risk factor (e.g. growth) relative to the overall market can also lead to under-performance, so it is important to understand where as well as how an investor is exposed. To take a UK-centric example, oil and mining shares under-performed global markets NOT because the economy was doing badly, but because they were Value-orientated investments (and as such, they are now doing well for the same reason, despite the low growth forecasts for the UK). A risk-efficient portfolio will take into account these issues, and should avoid some (but not all) of these problems.

Of course, this also has its drawbacks (since it is not possible to invest in EVERY single asset). The market portfolio is an ideal, not a reality. But at EBI, we strive to get as close as is practicable to that goal. In the long run, that is usually enough.

 

[1] It is possible for an company to have negative Enterprise Value – if cash held is greater than Market Cap , (possibly due to a bear market in equities), this could occur, but would not necessarily indicate a problem with a firm by itself. But if so, the question is begged as to its usefulness.