As value investors, we need to have an idea of the intrinsic value of a stock before we commit our capital. The calculation of the intrinsic value is dependent so much on the financial reports of the company. A lot of times it is the management's best interest to report better than expected earnings. How can we look through the reported numbers and find out the real information?
Robert Olstein is a CPA-turned money manager. He manages the $2 billion The Olstein Funds. Before he started his fund, he publishes a financial alert newsletter called "Quality of Earnings Report", which used inferential financial screening techniques to analyze balance sheets and income statements to alert institutional portfolio managers to positive or negative factors affecting a company's future earnings power and value of a company's stock. Since incepted in 1995, his fund has returned 14.89% in average per year. The key to his success is his capability of looking behind the numbers. In his most recent annual report, Robert Olstein detailed how he looks behind the numbers with financial reports. We have summarized and excerpted his key points here. You can certainly learn a thing or two from him.
Robert Olstein: All GAAP reporting systems rely on management judgment, leaving room for potential abuse or unrealistic assumptions.
- It is important to note that all (GAAP) reporting systems rely on management judgment, leaving room for potential abuse or unrealistic assumptions.
- Today, a wealth of additional information is contained in the footnotes and management discussions in annual reports, data which were not available 30 years ago for anyone who wanted to read with a skeptical eye.
- ... Generally Accepted Accounting Principles (GAAP) require that a company report earnings based on accrual accounting. The first premise of accrual accounting states that revenue is recognized when a transaction occurs in which value has been exchanged. The revenue recognition may lead or lag the passing of cash.
- The other basic premise of GAAP accrual accounting is that the cost of a transaction should be recognized over the same period of time that the revenue associated with the cost is generated. The cost or expense recognition also may lead or lag the passing of cash.
- In reporting GAAP-based earnings, companies are given wide discretion within the rules. Some companies make conservative assumptions, while others are overly aggressive, which can produce widely differing results depending on how management sees the future. In our opinion, most companies (including companies in our portfolio) engage in some type of earnings management. It is our job to determine the economic realism of management’s assumptions and to eliminate management biases by making the appropriate adjustments to reported earnings data. We believe there is nothing wrong or illegal about earnings management within limits. However, some companies exceed acceptable limits. In cases such as Lucent, Boston Chicken and Sunbeam, the financial statements may have been in accord with GAAP, but we don’t believe they were in accord with economic reality.
- It is in management’s best interest to report the best earnings possible to preserve financing alternatives, keep their stock options valuable and exercisable, and to keep shareholders happy through increasing stock prices. Thus, when a company’s management identifies problems deemed to be temporary, management has the option to adopt more optimistic assumptions. The optimism could result in income being recognized more rapidly because reserves are lowered or depreciation has been lengthened (over more years). The end result is that the reporting of an earnings disappointment is virtually eliminated under the belief that short-term problems will soon end.
- Unfortunately, in many cases, the future earnings disappointment that has been temporarily shelved becomes larger as the optimistic assumptions can no longer be justified. So even under GAAP (which we doubt was practiced by Enron), a true measure of the earnings power of a firm’s basic business can be distorted based on management’s biased view of reality.
Robert Olstein: How to look behind the numbers
- Using the company’s cash-flow statements, we begin by reconciling the difference between free cash flow and reported earnings under accrual accounting. The smaller the difference between free cash flow and reported earnings, the higher the quality of earnings.
- Our next step is to look at a company’s footnote on taxes, which reconciles the differences between earnings reported to shareholders under accrual accounting and earnings reported to the IRS under the cash basis of accounting. The lesser the difference, the higher the quality of earnings.
- We then analyze receivables and inventories to determine changes in each relative to changes in sales. Inventories or receivables increasing faster than sales could be early warning alerts of future slowdowns.
- The company’s investment activities are also extremely important to us, and we always compare depreciation provisions to capital expenditures when assessing sustainable free cash flow, the potential for future growth and management’s ability to create shareholder value. For example, a key alert to our purchase of Hasbro in February 2002 was that Hasbro’s cash earnings were being understated for many years as a result of depreciation exceeding capital expenditures. The excess depreciation was a result of expensing past capital spending on unprofitable licensing agreements that had since been terminated.
- The next step in our quest to measure the quality of earnings is to look for non-recurring factors that have contributed to or reduced earnings.
- Balance sheet ratios, especially relating to debt and returns on equity, are carefully assessed to determine a company’s ability to withstand temporary problems or an economic downturn without adopting harmful short-term strategies. The quality of earnings analysis relies heavily on analyzing these ratios. 7 Another important factor that we consider is the repetitiveness of socalled non-recurring losses, which we believe represent corrections to historical financial statements.
Robert Olstein: Top twenty quarlity of earning alerts
- Material deviations between net income and free cash flow
- Material differences between the tax books and shareholder books as measured by deferred taxes
- aterial changes in balance sheet debt and liquidity ratios
- Inventories, especially finished goods or raw materials, increasing or decreasing faster than sales
- Accounts receivable increasing or decreasing faster than revenue
- Deviations between depreciation and capital expenditures
- The repetitiveness and materiality of non-recurring write-offs
- The role that non-trend line changes in reserves contribute to, or negatively impact, current earnings
- The repetitiveness and materiality of non-recurring gains such as sales from venture capital portfolios
- The impact and reality of a company’s deferred expense capitalization policies as it effects reported free cash flow
- Discretionary expenses deviating materially above and below trend lines
- The reality, consistency and conservativeness of revenue recognition techniques when measured against the passing of cash
- The impact that acquisitions have on sustainable free cash flow and the growth thereof
- Changes in other asset accounts
- The impact of transactions with special-purpose vehicles
- Pension income and expense recognition measured against the pension plan’s assumptions and the funded status of the plan
- Large deviations between pro forma and reported earnings
- The impact of option transactions on reported free cash flow and the impact on future results and valuations of the company
- The capabilities of management as measured by their long-term decision- making capabilities; especially when problems develop; their attitude toward risk as measured by the quality of the balance sheet; and their preparation for a rainy day; their methodology of communicating with shareholders; and finally their ability and emphasis on returning value to shareholders
- Disclosure of material information needed to assess the value of the company
Are all these procedures sufficient to eliminate mistakes? Robert Olstein wrote: "Despite an exhaustive inferential analysis of their financial statements prior to purchase, once in a while one of the companies in our portfolio surprises us by engaging in questionable accounting practices." With more than 30 years of experience, the CPA-turned money manager still misses the questionable accounting practices sometimes. How can others without this strong accounting background do it? A few thoughts here:
- Buy simple business only. This is what Warren Buffett has been telling us. A simple business is easier to understand, and the chances of making questionable accounting practices are reduced.
- Stay in your circle of competence. Invest in industries you understand. Again Warren Buffett has been telling us this all the time.
- Buy companies with large insider ownership only, especially those operated by original founders. Owning a large portion of their company makes the CEOs think long term. Short term stock price moves are not in their interest.