Wednesday 28 March 2018

PER-SHARE EARNINGS: How Warren tells the winners from the losers

PER-SHARE EARNINGS: How WARREN TELLS THE WINNERS FROM THE LOSERS

Per-share earnings are the net earnings of the company on a per-share basis for the time period in question. This is a big number in the world of investing because, as a rule, the more a company earns per share the higher its stock price is. To determine the company's per-share earnings we take the amount of net income the company earned and divide it by the number of shares it has outstanding. As an example: If a company had net earnings of $10 million for the year, and it has one million shares outstanding, it would have per-share earnings for the year of $10 a share.

While no one yearly per-share figure can be used to identify a company with a durable competitive advantage, a per-share earnings figure for a ten-year period can give us a very clear picture of whether the company has a long-term competitive advantage working in its favor. What Warren looks for is a per-share earning picture over a ten-year period that shows consistency and an upward trend.

 Something that looks like this:


08
$2.95
07
$2.68
06
$2.37
05
$2.17
04
$2.06
03
$1.95
02
$1.65
01
$1.60
00
$1.48
99
$1.30
98
$1.42


This shows Warren that the company has consistent earnings with a long-term upward trend---an excellent sign that the company in question has some kind of long-term competitive advantage working in its favor. Consistent earnings are usually a sign that the company is selling a product or mix of products that don't need to go through the expensive process of change. The upward trend in earnings means that the company's economics are strong enough to allow it either to make the expenditures to increase market share through advertising or expansion, or to use financial engineering like stock buybacks.

The companies that Warren stays away from have an erratic earnings picture that looks like this:
                       

08
$2.50
07
         $(0.45) loss
06
$3.89
05
         $(6.05) loss
04
$6.39
03
$5.03
02
$3.35
01
$1.77
00
$6.68
99
$8.53
98
$5.24


This shows a downward trend, punctuated by losses, which tells Warren that this company is in a fiercely competitive industry prone to booms and busts. The booms show up when demand is greater than supply, but when demand is great, the company increases production to meet demand, which increases costs and eventually leads to an excess of supply in the industry. Excess leads to falling prices, which means that the company loses money until the next boom comes along. There are thousands of companies like this, and the wild price swings in shares, caused by each company's erratic earnings, create the illusion of buying opportunities for traditional value investors. But what they are really buying is a long, slow boat ride to investor nowhere.

NET EARNINGS: What Warren is looking for

NET EARNINGS: WHAT WARREN Is LOOKING FOR


                              Income Statement

($ in millions)  


Revenue
      $10,000
         Cost of Goods Sold
3,000
         Gross Profit
7,000


Operating Expenses

         Selling, General & Admin
2,100
         Research & Development
1,000
         Depreciation
   700
         Operating Profit
3,200


         Interest Expense
   200
         Gain (Loss) Sale Assets
1,275
         Other
    225
         Income Before Tax
1,500
         Income Taxes Paid
   525
         Net Earnings
 $975


After all the expenses and taxes have been deducted from a company's revenue, we get the company's net earnings. This is where we find out how much money the company made after it paid income taxes. There are a couple of concepts that Warren uses when he looks at this number that help him determine whether the company has a durable competitive advantage, so why don't we start there.

First on Warren's list is whether or not the net earnings are showing a historical upward trend. A single year's entry for net earnings is worthless to Warren; he is interested in whether or not there is consistency in the earnings picture and whether the long-term trend is upward---both of which can be equated to "durability" of the competitive advantage. For Warren the ride doesn't have to be smooth, but he is after a historical upward trend.

But note: Because of share repurchase programs it is possible that a company's historical net earnings trend may be different from its historical per-share earnings trend. Share repurchase programs will increase per-share earnings by decreasing the number of shares outstanding. If a company reduces the number of shares outstanding, it will decrease the number of shares being used to divide the company's net earnings, which in turn increases per-share earnings even though actual net earnings haven't increased. In extreme examples the company's share repurchase program can even cause an increase in per-share earnings, while the company is experiencing an actual decrease in net earnings.

Though most financial analysis focuses on a company's
per-share earnings, Warren looks at the business's net earnings to see what is actually going on.

What he has learned is that companies with a durable competitive advantage will report a higher percentage of net earnings to total revenues than their competitors will. Warren has said that given the choice between owning a company that is earning $2 billion on $10 billion in total revenue, or a company earning $5 billion on $100 billion in total revenue, he would choose the company earning the $2 billion. This is because the company with $2 billion in net earnings is earning 20% on total revenues, while the company earning $5 billion is earning only 5% on total revenues.

So, while the total revenue number alone tells us very little about the economics of the business, its ratio to net earnings can tell us a lot about the economics of the business compared with other businesses.

A fantastic business like Coca-Cola earns 21% on total revenues, and the amazing Moody's earns 31 %, which reflects these companies' superior underlying business economics. But a company like Southwest Airlines earns a meager 7%, which reflects the highly competitive nature of the airline business, in which no one airline holds a long-term competitive advantage over its peers. In contrast, General Motors, in even a great year---when it isn't losing money---earns only 3% on total revenue. This is indicative of the lousy economics inherent in the super-competitive auto industry.

A simple rule (and there are exceptions) is that if a company is showing a net earnings history of more than 20% on total revenues, there is a real good chance that it is benefiting from some kind of long-term competitive advantage. Likewise, if a company is consistently showing net earnings under 10% on total revenues it is---more likely than not---in a highly competitive business in which no one company holds a durable competitive advantage. This of course leaves an enormous gray area of companies that earn between 10% and 20% on total revenue, which is just packed with businesses ripe for mining long-term investment gold that no one has yet discovered.

One of the exceptions to this rule is banks and financial companies, where an abnormally high ratio of net earnings to total revenues usually means a slacking-off in the risk management department. While the numbers look enticing, they actually indicate an acceptance of greater risk for easier money, which in the game of lending money is usually a recipe for making quick money at the cost of long-term disaster. And having financial disasters is not how one gets rich.

The Income Statement: The Earning Test

3 Quick Tests for a Business with a long-term Durable Competitive Advantage:

1.   Earning Test
2.   Return (Profit) Test and
3.   Debt test.



1.       Earning Test

WHERE WARREN STARTS: THE INCOME STATEMENT


                              Income Statement

($ in millions)  


Revenue
      $10,000
         Cost of Goods Sold
3,000
         Gross Profit
7,000


Operating Expenses

         Selling, General & Admin
2,100
         Research & Development
1,000
         Depreciation
   700
         Operating Profit
3,200


         Interest Expense
   200
         Gain (Loss) Sale Assets
1,275
         Other
   225
         Income Before Tax
1,500
         Income Taxes Paid
   525
         Net Earnings
 $975


In his search for the magic company with a durable competitive advantage, Warren always starts with the firm's income statement. Income statements tell the investor the results of the company's operations for a set period of time. Traditionally, they are reported for each three-month period and at the end of the year. Income statements are always labeled for the time period they cover-such as January 1, 2007, to December 31, 2007.

An income statement has three basic componentsFirst, there is the revenue of the business. Then there is the firm's expenses, which are subtracted from the firm's revenue and tell us whether the company earned a profit or had a loss. Sounds simple, doesn't it? It is.

In the early days of stock analysis the leading analysts of the time, such as Warren's mentor Benjamin Graham, focused purely on whether or not the firm produced a profit, and gave little or no attention to the long-term viability of the source of the company's earnings. As we discussed earlier, Graham didn't care if the company was an exceptional business with great economics working in its favor or if it was one of the thousands of mediocre businesses struggling to get by. Graham would buy into a lousy business in a heartbeat if he thought he could get it cheaply enough.

Part of Warren's insight was to divide the world of businesses into two different groups: 
  • First, there were the companies that had a long-term durable competitive advantage over their competitorsThese were the businesses which, if he could buy them at a fair or better price, would make him superrich if he held them long enough. 
  • The other group was all the mediocre businesses that struggled year after year in a competitive market, which made them poor long-term investments.


In Warren's search for one of these amazing businesses, he realized that the individual components of a company's income statement could tell him whether or not the company possessed the super-wealth-creating, long-term durable competitive advantage that he so coveted. Not just whether or not the company made money. But what kind of margins it had, whether it needed to spend a lot on research and development to keep its competitive advantage alive, and whether it needed to use a lot of leverage to make money. These factors comprise the kind of information he mines from the income statement to learn the nature of a company's economic engine. To Warren, the source of the earnings is always more important than the earnings themselves.

For the next fifty chapters we are going to focus on the individual components of a company's financial statement and what Warren is searching for that will tell him if this is the kind of business that will send him into poverty, or the golden business with a long-term durable competitive advantage that will continue to make him one of the richest people in the world.

THE KIND OF BUSINESS THAT WILL MAKE WARREN SUPERRICH

THE KIND OF BUSINESS  THAT WILL MAKE WARREN SUPERRICH

To understand Warren's first great revelation we need to understand the nature of Wall Street and its major players. Though Wall Street provides many services to businesses, for the last 200 years it has also served as a large casino where gamblers, in the guise of speculators, place massive bets on the direction of stock prices.

In the early days some of these gamblers achieved great wealth and prominence. They became the colorful characters people loved reading about in the financial press. Big "Diamond" Jim Brady and Bernard Baruch are just a few who were drawn into the public eye as master investors of their era. 

In modern times institutional investors---mutual funds, hedge funds, and investment trusts---have replaced the big-time speculators of old. Institutional investors "sell" themselves to the masses as highly skilled stock pickers, parading their yearly results as advertising bait for a shortsighted public eager to get rich quickly.

As a rule, stock speculators tend to be a skittish lot, buying on good news, then jumping out on bad news. If the stock doesn't make its move within a couple of months, they sell it and go looking for something else.

The best of this new generation of gamblers have developed complex computer programs that measure the velocity of how fast a stock price is either rising or falling. If a company's shares are rising fast enough, the computer buys in; if the stock price is falling fast enough, the computer sells out. Which creates a lot of jumping in and out of thousands of different stocks.

It is not uncommon for these computer investors to jump into a stock one day, then jump out the next. Hedge fund managers use this system and can make lots and lots of money for their clients. But there is a catch: They can also lose lots and lots of money for their clients. And when they lose money, those clients (if they have any money left) get up and leave, to go find a new stock picker to pick stocks for them.

Wall Street is littered with the stories of the rise and fall of hot and not-so-hot stock pickers.

This speculative buying and selling frenzy has been going on for a long, long time. One of the great buying frenzies of all times, in the 1920s, sent stock prices into the stratosphere. But in 1929 came the Crash, sending stock prices spinning downward.

In the early 1930s an enterprising young analyst on Wall Street by the name of Benjamin Graham noticed that the vast majority of hotshot stock pickers on Wall Street didn't care at all about the long-term economics of the businesses that they were busy buying and selling. All they cared about was whether the stock prices, over the short run, were going up or down.

Graham also noticed that these hot stock pickers, while caught up in their speculative frenzy, would sometimes drive up the stock prices to ridiculous levels in relation to the long-term economic realities of the underlying businesses. He also realized that these same hotshots would sometimes send stock prices spiraling to insane lows that similarly ignored the businesses' long-term prospects. It was in these insane lows that Graham saw a fantastic opportunity to make money.

Graham reasoned that if he bought these "oversold businesses" at prices below their long-term intrinsic value, eventually the market would acknowledge its mistake and revalue them upward. Once they were revalued upward, he could sell them at a profit. This is the basis for what we know today as value investing. Graham was the father of it.

What we have to realize, however, is that Graham really didn't care about what kind of business he was buying. In his world every business had a price at which it was a bargain. When he started practicing value investing back in the 1930s, he was focused on finding companies trading at less than half of what they held in cash. He called it "buying a dollar for 50 cents." He had other standards as well, such as never paying more than ten times a company's earnings and selling the stock if it was up 50%. If it didn't go up within two years, he would sell it anyway. Yes, his perspective was a bit longer than that of the Wall Street speculators, but in truth he had zero interest in where the company would be in ten years.

Warren learned value investing under Graham at Columbia University in the 1950s and then, right before Graham retired, he went to work for him as an analyst in Graham's Wall Street firm. While there Warren worked alongside famed value investor Walter Schloss, who helped school young Warren in the art of spotting undervalued situations by having him read the financial statements of thousands of companies.

After Graham retired, Warren returned to his native Omaha, where he had time to ponder Graham's methodology far from the madding crowd of Wall Street. During this period, he noticed a few things about his mentor's teachings that he found troubling.

The first thing was that not all of Graham's undervalued businesses were revalued upward; some actually went into bankruptcy. With every batch of winners also came quite a few losers, which greatly dampened overall performance. Graham tried to protect against this scenario by running a broadly diversified portfolio, sometimes containing a hundred or more companies. Graham also adopted a strategy of getting rid of any stock that didn't move up after two years. But at the end of the day, many of his "undervalued stocks" stayed undervalued.

Warren discovered that a handful of the companies he and Graham had purchased, then sold under Graham's 50% rule, continued to prosper year after year; in the process he saw these companies' stock prices soar far above where they had been when Graham unloaded them. It was as if they bought seats on a train ride to Easy Street but got off well before the train arrived at the station, because he had no insight as to where it was headed.

Warren decided that he could improve on the performance of his mentor by learning more about the business economics of these "superstars." So he started studying the financial statements of these companies from the perspective of what made them such fantastic long-term investments.

What Warren learned was that these "superstars" all benefited from some kind of competitive advantage that created monopoly-like economics, allowing them either to charge more or to sell more of their products. In the process, they made a ton more money than their competitors.

Warren also realized that if a company's competitive advantage could be maintained for a long period of time---if it was "durable"---then the underlying value of the business would continue to increase year after year. Given a continuing increase in the underlying value of the business, it made more sense for Warren to keep the investment as long as he could, giving him a greater opportunity to profit from the company's competitive advantage.

Warren also noticed that Wall Street---via the value investors or speculators, or a combination of both---would at some point in the future acknowledge the increase in the underlying value of the company and push its stock price upward. It was as if the company's durable competitive advantage made these business investments a self-fulfilling prophecy.

There was something else that Warren found even more financially magical. Because these businesses had such incredible business economics working in their favor, there was zero chance of them ever going into bankruptcyThis meant that the lower Wall Street speculators drove the price of the shares, the less risk Warren had of losing his money when he bought in. The lower stock price also meant a greater upside potential for gain. And the longer he held on to these positions, the more time he had to profit from these businesses' great underlying economics. This fact would make him tremendously wealthy once the stock market eventually acknowledged these companies' ongoing good fortune.

All of this was a complete upset of the Wall Street dictum that to maximize your gain you had to increase your underlying risk. Warren had found the Holy Grail of investments; he had found an investment where, as his risk diminished, his potential for gain increased.

To make things even easier, Warren realized that he no longer had to wait for Wall Street to serve up a bargain price. He could pay a fair price for one of these super businesses and still come out ahead, provided he held the investment long enough. And, adding icing to an already delicious cake, he realized that if he held the investment long-term, and he never sold it, he could effectively defer the capital gains tax out into the far distant future, allowing his investment to compound tax-free year after year as long as he held it.

Let's look at an example: In 1973 Warren invested $11 million in The Washington Post Company, a newspaper with durable competitive advantage, and he has remained married to this investment to this day. Over the thirty-five years he has held this investment, its worth has grown to an astronomical $1.4 billion. Invest $11 million and make $1.4 billion! Not too shabby, and the best part is that because Warren has never sold a single share, he still has yet to pay a dime of tax on any of his profits.

Graham, on the other hand, under his 50% rule, would have sold Warren's Washington Post investment back in 1976 for around $16 million and would have paid a capital gains tax of 39% on his profits. Worse yet, the hotshot stock pickers of Wall Street have probably owned this stock a thousand times in the last thirty-five years for gains of 10 or 20% here and there, and have paid taxes each time they sold it. But Warren milked it for a cool 12,460% return and still to this day hasn't paid a red cent in taxes on his $1.4 billion gain.

Warren has learned that time will make him superrich when he invests in a company that has a durable competitive advantage working in its favor.


Tuesday 27 March 2018

How To Evaluate The Quality Of EPS

How To Evaluate The Quality Of EPS

by Rick Wayman
Earning per share (EPS) manipulation might be the second oldest profession, but there is a relatively easy way for investors to protect themselves. This article will show you how to evaluate the quality of any kind of EPS, and find out what it's telling you about a stock.

Tutorial: Examining Earnings Quality
Overview
The evaluation of earnings per share should be a relatively straightforward process, but thanks to the magic of accounting, it has become a game of smoke and mirrors, accompanied by constantly mutating versions that seem to have come out of "Alice in Wonderland". Instead of Tweedle-Dee and Tweedle-Dum we have pro forma EPS and EBITDA. And, despite rumors to the contrary, the whisper number - the Cheshire cat of Wall Street - continues to exist as guidance.

To be fair, this situation cannot be totally blamed on management. Wall Street deserves as much blame due to its myopic focus on the near-term and knee-jerk reactions to 1 cent misses. A forecast is always only a guess - nothing more, nothing less - but Wall Street often forgets this. This, however, does create opportunities for investors who can evaluate the quality of earnings over the long run and take advantage of market overreactions. (For background reading, check out Earnings Forecasts: A Primer.)


EPS Quality
High-quality EPS means that the number is a relatively true representation of what the company actually earned (i.e. cash generated).  But while evaluating EPS cuts through a lot of the accounting gimmicks, it does not totally eliminate the risk that the financial statements are misrepresented. While it is becoming harder to manipulate the statement of cash flows, it can still be done.
A low-quality EPS number does not accurately portray what the company earned. GAAP EPS (earnings reported according to Generally Accepted Accounting Principles) may meet the letter of the law but may not truly reflect the earnings of the company. Sometimes GAAP requirements may be to blame for this discrepancy; other times it is due to choices made by management. In either case, a reported number that does not portray the real earnings of the company can mislead investors into making bad investment decisions. 

How to Evaluate the Quality of EPS
The best way to evaluate quality is to compare operating cash flow per share to reported EPS. While this is an easy calculation to make, the required information is often not provided until months after results are announced, when the company files its 10-K or 10-Q with theSEC.

To determine earnings quality, investors can rely on operating cash flow. The company can show a positive earnings on the income statement while also bearing a negative cash flow. This is not a good situation to be in for a long time, because it means that the company has to borrow money to keep operating. And at some point, the bank will stop lending and want to be repaid. A negative cash flow also indicates that there is a fundamental operating problem: either inventory is not selling or receivables are not getting collected. "Cash is king" is one of the few real truisms on Wall Street, and companies that don't generate cash are not around for long. Want proof? Just look at how many of the dotcom wonders survived! (To learn more about what happened, see Why did dotcom companies crash so drastically?)

If operating cash flow per share (operating cash flow divided by the number of shares used to calculate EPS) is greater than reported EPS, earnings are of a high quality because the company is generating more cash than is reported on the income statement. Reported (GAAP) earnings, therefore, understate the profitability of the company.

If operating cash flow per share is less than reported EPS, it means that the company is generating less cash than is represented by reported EPS. In this case, EPS is of low quality because it does not reflect the negative operating results of the company and overstates what the true (cash) operating results. 
  
Watch: Earning Per Share


An Example
Let's say that Behemoth Software (BS for short) reported that its GAAP EPS was $1. Assume that this number was derived by following GAAP and that management did not fudge its books. And assume further that this number indicates an impressive growth rate of 20%. In most markets, investors would buy this stock.

However, if BS's operating cash flow per share were a negative 50 cents, it would indicate that the company really lost 50 cents of cash per share versus the reported $1. This means that there was a gap of $1.50 between the GAAP EPS and actual cash per share generated by operations. A red flag should alert investors that they need to do more research to determine the cause and duration of the shortfall. The 50 cent negative cash flow per share would have to be financed in some way, such as borrowing from a bank, issuing stock, or selling assets. These activities would be reflected in another section of the cash flow statement.

If BS's operating cash flow per share were $1.50, this would indicate that reported EPS was of high quality because actual cash that BS generated was 50 cents more than was reported under GAAP. A company that can consistently generate growing operating cash flows that are greater than GAAP earnings may be a rarity, but it is generally a very good investment. (To learn more about this metric, check out Operating Cash Flow: Better Than Net Income?)

Trends Are Also Important
Because a negative cash flow may not necessarily be illegitimate, investors should analyze the trend of both reported EPS and operating cash flow per share (or net income and operating cash flow) in relation to industry trendsIt is possible that an entire industry may generate negative operating cash flow due to cyclical causes. Operating cash flows may be negative also because of the company's need to invest in marketing, information systems and R&D. In these cases, the company is sacrificing near-term profitability for longer-term growth.

Evaluating trends will also help you spot the worst-case scenario, which occurs when a company reports increasingly negative operating cash flow and increasing GAAP EPS. As discussed above, there may be legitimate reasons for this discrepancy (economic cycles, the need to invest for future growth), but if the company is to survive, the discrepancy cannot last long. The appearance of growing GAAP EPS even though the company is actually losing money can mislead investors. This is why investors should evaluate the legitimacy of a growing GAAP by analyzing the trend in debt levels, times interest earned, days sales outstanding and inventory turnover. (To learn about why companies fudge cash flow, readCash Flow On Steroids: Why Companies Cheat.)

The Bottom Line
Without question, cash is king on Wall Street, and companies that generate a growing stream of operating cash flow per share are better investments than companies that post increased GAAP EPS growth and negative operating cash flow per share. The ideal situation occurs when operating cash flow per share exceeds GAAP EPS. The worst situation occurs when a company is constantly using cash (causing a negative operating cash flow) while showing positive GAAP EPS. Luckily, it is relatively easy for investors to evaluate the situation. 

by Rick Wayman