Finding Value (or Not) Beyond Net Income
The Value of a an established corporation should normally be reflected in its
Net Income. However, there are many cases where value has been created but it is
not (yet) showing up in net income, even after adjusting net income for any
unusual losses or charges.
If a company is trading on its net income value, an investor may be able to
identify a bargain if he or she can discover hidden value that is not being
reflected in net income.
A more frequent situation is where a company appears to be trading at an
unreasonable multiple of net earnings. Companies often ask investors to ignore
net income and instead focus on various measures of cash flow or cash
distributions or assets. In these cases the investor needs to be able to
understand why the company is worth more than its earnings would suggest.
Understanding this will allow investors to avoid companies that are in fact
over-valued. Investors will be better able to recognize when net income may
indeed be under-stating the value of the company.
Companies can be creating hidden value in all three components of the
Cash Flow Statement, Operations,
Investments and Financing.
Hidden Value in Operations:
GAAP net income shows up in the operations section of the cash flow
statement. If net income is under-stated this can create hidden value. Examples
of under-stated net income include.
Deferred or Future Income Tax: This occurs when the accounting income tax is
higher than the actual income tax. It could be argued that this is a phantom
expense. It represents a tax expense that will be due in the future. However,
growing companies are often able to continually defer a growing amount of income
tax. Deferral of income tax always creates at least some hidden value due to the
time value of delaying income taxes. In some cases the entire amount of deferred
income tax is essentially hidden earnings since the deferral may be virtually
permanent. On average, it's probably prudent to add back about half of the
deferred income tax as additional adjusted income.
Expenses that create future benefits. Customer acquisition costs to
acquire customers that are expected to remain as customers for many months or
years are often expenses even though they create future benefits. Examples
include commissions paid to acquire cell phone, insurance, and cable T.V.
customers and apartment rental incentives. Some companies do defer these
expenses. It is in cases where they are expenses rather than capitalized or
deferred that hidden value may be created. Unfortunately is is difficult to know
how much of these expenses (net of tax) should be added back to create a more
realistic adjusted net income. Some analysts attempt to reconstruct the income
statement as if these expenses had been capitalized and then amortized over a
reasonable period of years.
Depreciation that is greater than maintenance capital spending. In
some industries that use long-lived assets, there may be little maintenance
capital spending required. In that case most of the depreciation expense truly
is a non-cash expense and should be added back to net income. However, investors
should be cautious because companies may claim all of the depreciation is
non-cash when in fact much of it is being spent on maintenance capital spending.
The portion of depreciation that exceeds annual average maintenance capital
spending is creating value and should be added back to adjusted net income.
Research expenses are usually conservatively expensed under GAAP even
though they are expressly designed to benefit future years. As long as the
research is creating something useful, this definitely creases a hidden value
not reflected in net income.
Hidden Value In Investments
In certain situations it may be possible for a company to buy assets for say
50 cents on the dollar. Since the asset is recorded at cost the hidden value
that has been created does not immediately show up. Instead it will show up in
future years through a higher return on equity. Energy Royalty Trusts may be
benefiting from this now. Oil and Gas assets are worth more to Trusts than they
are to taxable corporations. Therefore if there are many corporations selling
assets, then the Trusts may be getting assets for cents on the dollar and
creating hidden value. This could end badly if the supply of assets changes such
that their are more Trusts buying than Corporations selling. The Trusts would
then not be able to buy for cents on the dollar. Another example of where this
occurs is when a public company can buy and fold in small private firms. The
private assets may suffer from a liquidity discount and it may be possible, for
a publicly traded company, to buy them for cents on the dollar. I believe that
this has been part of the success of Stantec and of First Services Inc.
Hidden Value in Financings
There is a technique that can be used when a companies shares are
over-valued due to excessive hype or attention toward the stock. In this
situation, the wise company tries to sell substantial equity at the high price,
ostensibly to fund expansion. The result is that the book value per share rises.
The company can use some of the funds raised to pay down debt. Even if the
excitement dies down, the increase in book value per share can provide a floor
of value under the shares. In the end shareholders would have been better off
selling at the peak. But the company may brag about how its share price or book
value per share rose over the years (ignoring that the spike in share price that
creates this opportunity).
I believe that this phenomena was at work near the IPO of Boardwalk Inc. It
also clearly occurred with FairFax Financial which created a phenomenal 31%
annual increase in book value per share, in the 18 years ending 2003. This is
exceptional by any measure. But it was created not simply by retained net
income. Rather a good portion of it was created by selling shares, when it had
the chance at over 3 times book value and later buying shares back when it had
the chance at less than book value. During this period Fairfax had a very
good annual average ROE of 16.0% but the additional 15% per year increase in
book value per share apparently came from shrewd sales of stock and buy-backs at
opportune stock prices. Investors would have been far better off to have sold
when the share price peaked. This is a type of hidden value that did not "run
through" the net earnings. But investors cannot expect to benefit from this in
the future, since it depends on selling shares at inflated prices. It does
indicate an astute management. Most managements like that of Nortel were ,
frankly, too stupid to sell substantial shares when their stocks were flying
ridiculously high. They actually believed that their stock deserved to be that
high when a more financially literate management would have known better.
This phenomena may also be occurring today with various Income Trusts,
including Royalty Trusts. On average they are paying out double their earnings
and so may be over-valued. (they would claim distributable cash flow is at lest
double earnings, and only time will tell if their disrespect of GAAP is
justified). Possibly they are using the cash from over-priced unit sales to
shore up the balance sheet. Capital spending that is required to merely maintain
operations could be passed off as growth oriented capital spending. It certainly
increases book value per unit. However, if units are indeed over-valued then
this will eventually become apparent and unit prices will fall.
END
Shawn C. Allen, CFA, CMA, MBA, P.Eng.
President, InvestorsFriend Inc.
October 9, 2004