Successful asset leveraging shows up in the income statement.
The income statement reports revenues less expenses and depicts an important measure of business performance. This is not a picture of cash flows because GAAP uses accrual, not a cash method of reporting.
In accrual accounting, economic activity is recorded according to the relationship between revenue and expense, rather than the timing of cash inflows or outflows. This is not an idiosyncrasy of accounting tradition, but a reflection of accounting’s goal of measuring and allocating business events that reflect economic reality. Those accruals capturing noncash costs of doing business reflect that cash will be absorbed in the future.
Pure value investors (Graham and Dodd) believe that current earnings (adjusted) are the most reliable indicator of a company’s sustainable long-term cash flows.
Adding a further constraint, pure value investors believe that the most reliable way to use current earnings as a valuation metric is to assume they will be constant in the future at current rates – not grow according to estimates.
The math is easy.
Valuation based on current earnings is equal to current earnings divided by the company’s current cost of capital.
That is,
V = E/k.
E = Earnings are earnings.
k = The cost of capital. (This is the company’s weighted average cost of debt and cost of equity. The former can be calculated simply; the latter still requires some estimating).
The virtues of this approach are simplicity and reliability:
- Characteristic of simplicity is that investors need not bother with growth rates because no growth is assumed.
- Both data points are known or can be reliably estimated.
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