For the intelligent investor, this creates a problem that can potentially cause material differences (depending on the figure chosen) in estimates of intrinsic value and in the calculation of key metrics. Due to its applicability across multiple industries, Generally Accepted Accounting Principles (GAAP) has a highly subjective component that can create a lot of confusion for the analyst, and might not accurately represent “true” economic earnings. What is one to do? Take GAAP earnings for what they’re worth? Take management for their word?
Luckily, Ben Graham, the father of value investing, listed seven steps in "Security Analysis" for adjusting the accounting numbers in the analysis of the income statement in order to arrive at a better estimate of "true" earnings power. They are as follows:
1. Deal properly with nonrecurring items
2. Eliminate unjustified income recognition
3. Direct entries to surplus
4. Use comparable inventory and depreciation methods
5. Consolidate affiliates
6. Provide for income taxes
7. Record absent assets and liabilities
The step-by-step guide for these seven items covers eight chapters and more than 200 pages in the book, so I will break them down into separate articles. At the end of the exercise, my goal is to provide a clear framework for how to estimate earnings power from reported (GAAP) earnings, and to complete a case study to test the applicability of Mr. Graham’s methodology today. Today’s article will start from the top of the list.
DEAL PROPERLY WITH NONRECURRING ITEMS
Nonrecurring items are those that occur outside of the course of regular business operations. This category can be broken down into two separate groups: those events that occurred in the past years (like tax adjustments/forgiveness, litigation/claims, or accounting changes) and those that originated in the current year (like asset sales). Generally, nonrecurring items can be dealt with in three ways: single year allocation, straight line spreading, or by excluding the item altogether.
Allocating the gains/losses to a single year does not seem like the right answer (Graham calls it the least appropriate method); must like property, plant, and equipment costs are smoothed out via depreciation to replicate their “actual” cost, it is illogical to record an asset sale as a one year earnings increases when attempting to calculate “true” earnings.
Straight line spreading is the easiest to calculate, but it may misrepresent the economics of the situation. However, over a long term analysis, this may be the best rule for the analyst when estimating historical earnings power (besides charges that are clearly unrelated to normal operations of the business).
Graham also suggests that the analyst can exclude the resulting gain or loss altogether; an example is capital transactions (like early retirement of debt), which he believes are best excluded from current year results. However, if this is the method chosen, you must adjust the tax effects resulting from the gain/loss as well, which involves adjusting the tax rate to apply the appropriate rate after the adjustment is made (a task many individual investors would be uncomfortable with).
For events from previous years, the analyst should include the results for a period of years (straight line), but only in the years that they are applicable (which is likely highlighted in the charge). An example would be a tax refund received in 2011 for overpayment of taxes on income in 2008 and 2009; in this situation, the analyst should eliminate the refund from 2011, and restate the taxes (and thus earnings) for the two years in question. An important realization due to the inherent subjectivity in choosing one of these methods is that the analyst should not use single-year earnings as a justification for valuation; you must use a historical measure of adjusted earnings in order to accurately measure the earnings power of the enterprise in question.
Regardless of the methodology chosen, the analyst must use a consistent and rational approach in regards to nonrecurring items. Graham offers three suggestions in this exercise:
1. Small items (affecting net income by less than 5%) should be accepted as reported.
2. When an item is excluded, an adjustment must be allowed for income tax deduction.
3. Most items excluded from a single year analysis must still be included in a statement of long-term (average) results.
As with GAAP, accounting for nonrecurring items is far from an exact science. Based on Graham’s writings, it appears that understanding the charge and its implications on the business operations of the company in question is critical when allocating the gain/loss. For the investor, this means understanding the nature of the charges in question, and how they relate to the company’s economic situation. Again, while this may not be easy, it is a key step when attempting to calculate “true” earnings; for the intelligent investor, developing a consistent and logical approach to accounting for nonrecurring items is of the utmost importance.