1. Deal properly with nonrecurring items – SEE HERE
2. Eliminate unjustified income recognition
3. Direct entries to surplus – SEE HERE
4. Use comparable inventory and depreciation methods
5. Consolidate affiliates
6. Provide for income taxes
7. Record absent assets and liabilities
As I’ve noted previously, I’m going to skip the second step (eliminate unjustified income recognition) for a later date because it is associated in some way with nearly every step above, and will be more useful in the closing discussion. For this article, I will focus on the forth step, which deals with inventory valuation and depreciation/amortization expense, and how the analyst can place them on a comparable basis for equity analysis.
USE COMPARABLE INVENTORY AND DEPRECIATION METHODS
The methodology for approaching the inventory account and depreciation (as laid out by Ben Graham) has two key components. The first step is to adjust each expense in order to calculate normalized earnings power and (less importantly) actual asset values. The second step is to separate companies into distinct groups/industries, and to apply the same accounting basis to like enterprises in order to permit comparable analysis.
The discussion on inventory is centered on LIFO and FIFO accounting, and the differences between the two (Investopedia has a good discussion on the topic here) in relation to net income and financial ratios. Many companies tend to use LIFO, which reduces income taxes in times of inflation; as such, Ben Graham suggests that the security analyst adjusts the inventories/earnings of those using FIFO in order to conform to the majority of enterprises. The basic equations needed to complete this adjustment are:
(1) Beginning inventory + Purchases – Ending Inventory = COGS, and
(2) LIFO Inventory + LIFO Reserve = FIFO Inventory; or FIFO Inventory – LIFO Reserve = LIFO Inventory
The appropriate/needed figures can be found in the reported balance sheet (for #1) and in the footnotes of the 10-K (for #2). Graham suggests that the analyst uses FIFO on the balance sheet (for inventories) and LIFO on the income statement (for COGS); however, this creates an issue where the balance sheet and the income statement no longer joined because changes in equity are no longer explained in the income statement. When calculating investment value through earnings power as a going concern, it is suggested that the analyst stick with a LIFO measurement; when looking at liquidation/asset value, it is suggested that the analyst uses FIFO for inventory valuation.
A critical analysis of any income statement must focus on the depreciation and other noncash charges deducted. Graham suggests that investors be guided by three basic principles when approaching depreciation and other amortizations:
Make sure the amortization provision is adequate by conservative standards
Apply (to the extent possible) uniform depreciation measures for comparative companies
Maintain a sense of proportion, avoiding items have no appreciable influence on conclusions reached
For many industries, depreciation/amortization expenses are of paramount importance (as compared to net income); for the analyst, being able to detect and evaluate deviations from the norm is a key tool for equity valuation.
The recommended way of dealing with differing depreciation methodologies is to put all companies (within any industry) on a comparable basis. One method recommended is to put all companies on a straight line basis, using the industry-average depreciation rate (calculated as depreciation expense to gross plant). At this point, the analyst can use this equation:
(Company depreciation to gross plant – Industry depreciation to gross plant) x (Company gross plant) x (1 – tax rate) = adjustment to net income
The resulting adjustment is added or subtracted (respectively) to/from net income.
One area to note is purchase goodwill (and it’s amortization), which occurs when a business is acquired beyond the fair value of its net assets (book value). Graham suggests that the analyst completely writes off this goodwill, and remove its subsequent amortization from the income statement.
As I’ve noted before, most necessary adjustments will be company/industry specific; there is not simply a list of all-encompassing generic rules that can be applied across the investment universe. For example, if you are following drug companies, R&D expenses will be a much larger percentage of overall expenses than in most industries, and must be adjusted accordingly to accurately represent the economic reality. The analyst must develop an adequate understanding of the company’s expenses and how they relate to the business operations (i.e., the time period to spread the expense over) in order to adjust the income statement and develop an accurate representation of “true” earnings.