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Geoff Gannon
Geoff Gannon
Articles (304) 

A Two-Step Approach to Assessing 'Earnings Quality'

A stock deserves a higher P/E if it converts more EPS to free cash flow and reallocates that free cash flow into high return on investment uses. Low 'earnings quality' stocks deserve a low P/E

February 09, 2018 | About:

One of the most important tasks a value investor has is judging “earnings quality.” A stock’s P/E ratio tells you something. But, it doesn’t tell you enough. And the longer you are invested in a stock – the less it tells you. Value investors often try to fix this problem by focusing on free cash flow instead of earnings per share. They also think a lot about return on invested capital. For example, Joel Greenblatt (Trades, Portfolio)’s “The Magic Formula” uses EV/EBIT (which is a pre-tax P/E ratio that counts debt as part of the price) as a sort of earnings measure combined with last year’s return on capital.

However, there are a few problems with a true stock picker – not a buyer of a formulaic basket – using that approach. One, you aren’t going to sell the stock in one year. So, return on capital might change quite a bit while you own the stock. Two, earnings are an accounting – rather than an economic – number. This is why Tobias Carlisle’s “The Acquirer’s Multiple” which is based on the simple EV/EBITDA approach (with no return on capital consideration) might work just as well. An acquirer doesn’t actually think in terms of reported earnings or even EBIT. An acquirer uses a measure of cash flow vs. the price of debt and equity in the business. So, an EV/EBITDA approach is closer to a cash approach. Also, it’s possible that return on capital may “revert to the mean.” There’s actually a lot of evidence that in well settled, non-cyclical industries reversion to the mean in terms of returns on capital is pretty weak. For example, in restaurants – Starbucks (SBUX), Dunkin Donuts (DNKN), and Domino’s (DPZ) – there is strong profit persistence where the coffee chain, pizza chain, etc. with the highest return on capital keeps having the highest return on capital and the ones with the lowest keep having the lowest. Think about what the return on capital is for two leaders in coffee – Starbucks and Dunkin Brands – and then try to imagine what it is for everyone else. You just don’t see the same reversion to the mean that you see in cyclical industries like insurance, semiconductors, etc. This persistently high level of profitability among companies who are leaders, have better business models, etc. is why Warren Buffett (Trades, Portfolio) could make bets that pay off over long periods of time. He has owned Wells Fargo (WFC) for about 28 years and has outperformed what he could do by picking a random bank. Returns on capital can completely avoid reversion to the mean in situations where you have excellent product economics and low growth in tangible assets. For example, Berkshire Hathaway (NYSE:BRK.B) has owned See’s Candies for a very long time and had a very high return on capital – but, what hasn’t it done? It hasn’t opened many See’s Candies locations in states where the brand wasn’t already well established. Likewise, Nebraska Furniture Mart can have strong economics versus other furniture stores – but it’s actually had very low growth in terms of the number of locations, square footage, etc.

This brings us to the issue of re-investment of capital. So, a company’s economic earnings are what it earns in actual free – that is, distributable by the owner – cash flow. We know See’s Candies has high free cash flow, because Warren Buffett (Trades, Portfolio) has taken the cash from See’s and invested in other things. He has bought other businesses, stocks, etc. using the cash flow from See’s. That proves that See’s “earnings quality” is high. It earned money in cash flow that can be used elsewhere. But, for Berkshire – and really any company that’s only half the “earnings quality” equation. To be of high quality, earnings must come in the form of cash. If a company keeps growing its inventory and receivables year after year, but never seems to grow its cash balance – that earnings quality is low. If a cruise line keeps growing the size of its fleet year after year – but never has more cash on hand at year end, the earnings quality there is suspect as well. A business that “earns” in the form of additional tangible investment in day-to-day operations has low quality earnings.

But, even a business with high free cash flow can have low earnings quality. This is because there are really two parts to earnings creating added stock market value. If a company earns $1, there is first the question of whether 85 cents, 90 cents, 95 cents or 105 cents is generated in free cash flow. The worst businesses – often those with large amounts of property, plant, and equipment and receivables and inventory – may generate just 80 cents in cash for every one dollar of earnings they report. Meanwhile, the best businesses – take something like the ad agency holding company Omnicom (NYSE:OMC) – may generate 5 or 6 cents more in free cash flow for every dollar of earnings they report. In other words, such a stock reporting $5 in EPS might actually have up to $5.30 in free cash flow in a “normal” year. Still, this is only half the “earnings quality” equation from the shareholder’s perspective.

The next question is what use that free cash flow will be put to. This is where Berkshire Hathaway excels. Warren Buffett (Trades, Portfolio) harvests $1 of free cash flow from a subsidiary that isn’t growing and he turns it into more than $1 of added market value to Berkshire stock by picking the right stocks, buying the right businesses, etc. with the free cash flow. Many companies don’t do this. And poor capital allocation lowers earnings quality.

Let’s return to the example of Omnicom. In recent years, Omnicom’s earnings quality has decreased a bit in the sense that it has generated less free cash flow per dollar of reported earnings. But, the level of free cash flow relative to reported EPS is still very high. That’s a core part of the business model. And it doesn’t change much from say 1998 to 2003 to 2008 to 2013 to today.

What does?

The value created or destroyed by capital allocation. The incremental return on the free cash flow once it is re-deployed has changed a tremendous amount. For the permanent shareholder, one dollar of free cash flow today at Omnicom should be worth much, much more than $1 of free cash flow back in 1998. That’s because Omnicom re-deploys a lot of its cash through investment in its own stock. It buys back its shares. The price of its shares in 1998 was very high in terms of P/E ratio, EV/Sales, etc. Today, it’s much lower. This means the earnings quality of the stock is now higher because of the “second step” in the process. A shareholder in Omnicom doesn’t really get that much free cash flow paid out to him. He gets some. There’s a decent dividend yield on the stock right now. But, historically, more of the company’s EPS has been paid out in the form of stock buybacks than in the form of dividends. It’s important to consider the return on investment of each use of free cash flow.

Omnicom has very little need for tangible capital growth inside its business. It does acquire some companies (though, it acquires less than some of its peers). So, the P/E ratio alone isn’t sufficient to judge Omnicom. Instead, an investor needs to look at that P/E ratio (which is EPS/Stock Price) and then think about the “second round” earnings quality. The first round is the generation of free cash flow. As I said this often exceeds EPS – so that part has high “earnings quality.” But, the company blindly buys back stock. It isn’t very sensitive to price with its buybacks. This makes the ultimate value of free cash flow – the “value add” to intrinsic value – differ quite a bit depending on the stock’s price. Omnicom becomes much more attractive for a long-term holder of the stock whenever the stock price gets cheap and is likely to stay cheap for a while. The stock has sometimes been cheap enough to ensure about a 10% return on stock buybacks. That’s impressive when you consider the EPS conversion to free cash flow has been greater than 100% at times. When Omnicom stock is cheap – about where it is now or even cheaper – a long-term shareholder is getting an extremely high earnings quality. The P/E might say 15, but the P/FCF ratio is even lower. And then a good deal – sometimes even two-thirds – of the EPS is going into buying back the shares. Let’s say the P/FCF ratio is 14. That’s a free cash flow yield of 7%. Maybe 3% of that will go to dividends. But, the other 4% will go to share buybacks. If the 4% that goes to share buybacks has a long-term buy and hold type return of 10% or more on its share buybacks – that elevates the value add for the stock. This is because the market will capitalize a stock like Omnicom at an earnings yield of maybe 6% (like a P/E of 16 or 17) when the stock can re-invest (in itself) at 10% or more (the stock it buys both generates earnings right away and then also grows over time). In a sense, the market is demanding a 6% return and the re-investment is giving the company a 10% return.

This is an important point. But, I’m sure it sounds kind of trivial to you right now. After all, many companies have much, much higher returns on equity than 10%. That’s true. But, therein lies the problem with something like “The Magic Formula” or with the ROE number you see here at GuruFocus.

Remember: three things matter while you hold a stock. One is pretty speculative. It’s what the market will capitalize earnings at when you want to sell the stock (in other words, how high will the P/E will be). That’s your “sell” return. But, the other two things that matter are “hold” returns. They are: #1) How much free cash flow will the stock generate? And #2) What will this free cash flow be used for? To make money in the stock, you want three things to happen. One: You want a lot of free cash flow generation. Two: You want the free cash flow to be re-invested in a way that creates more earnings power relative to the free cash flow being consumed. And three: you want a high multiple put on the ending free cash flow generation when you sell the stock.

If a company buys back its stock at a high P/E ratio, the ultimate “earnings quality” is actually low. And the stock will perform worse than you expect or the stated return on investment would suggest. For example, look at Intel (INTC) around the year 2000. That company bought back stock to offset employee stock option issuance. The financial statements said Intel had pretty good “earnings quality” because it was generating a lot of free cash flow. But, investors didn’t get to see that free cash flow paid out to them. Instead, the free cash flow was used to reduce the company’s share count. This was not an effective way to grow future free cash flow per share. The company paid too much in terms of free cash flow now to grow free cash flow later. The “all in” earnings quality was poor. Intel’s operations were good. Its capital allocation was poor. This made the stock’s “earnings quality” mediocre.

This kind of “earnings quality” problem is one investors in high debt companies face a lot. It can be a surprisingly bad decision to invest in a highly leveraged company that de-leverages while you own it. This sounds like a nice scenario at first. After all, the stock gets safer. But, if the company’s credit rating starts out decent – paying down debt is usually a really bad use of funds. We can look at General Electric (NYSE:GE) today.

Personally, I’m interested in GE as a value investment but very worried about GE in terms of “earnings quality.” One, I’m worried that some segments of GE may only convert 80% or less of their reported earnings into free cash flow. And then, two: I’m worried that – if I became a stock owner today – some of that free cash flow would go to plugging the company’s pension obligations. That’s a very low return use of cash.

For example, imagine that GE stock trades at a P/E of 13, so an earnings yield of 7% to 8%. But, then only 80% of that earnings yield is turned into free cash flow. That gets you to a free cash flow yield of 6%. But, imagine a worst case scenario where GE used all of the free cash flow – this is an extreme assumption I’m using just to illustrate a point – to plug the pension hole. Well, the return on doing something like that could be as low as 5%. That’s two-thirds of what the return in buying back the company’s stock would be – even if the company didn’t grow. I should make the point here that the company did buy back stock at an earlier date. But, buying the stock back now would be a higher return decision than when the company chose to do a big buyback. Still, GE is unlikely to do a big buyback now. It really might do something like shore up the pension funding instead of buying back stock. So, you can quickly get to a scenario where a P/E of 13 on a company with a EPS to free cash flow conversion rate of 80% and then a capital allocation program with a 5% return on investment is no better than a stock with a P/E of 25 that converts at least 100% of EPS into free cash flow and pays it all out in dividends. The explanation for why a company with a P/E of 25 can sometimes be as attractive as a company with a P/E of 13 is “earnings quality” differences. If a company generates more cash per dollar of earnings than another company and it uses that cash better – it can be a better investment even at a higher P/E ratio.

And, if my suggestion of a 5% return on investment seems totally outlandish to you – after all, stocks usually have much, much higher ROEs than that – consider that quite a few big companies have had returns on acquisitions that really are about that bad. And some of the worst returning acquisitions have had some of the biggest price tags.

Usually, a company’s core day-to-day operations have much better return potential than any kind of activity it can undertake in the corporate finance department.

So, a big part of getting into a high “earnings quality” stock is simply avoiding companies that make a lot of acquisitions, buy back their stock when it’s overpriced, or pay off debt that’s fairly low yielding.

When analyzing a stock, it can be a huge help to know it won’t make any acquisitions or that it will spend all its free cash flow on dividends or share buybacks. This greatly simplifies the earnings quality calculation. We now know that GE’s earnings quality was poor in recent years. It might have been hard to detect that ahead of the bad recent results. However, it would have been easy to see that there was no way to be sure GE had high “earnings quality.” It was too difficult to assess the “earnings quality.” Stocks with low earnings quality or difficult to assess earnings quality should have below market P/E ratios – not above market P/E ratios. They should only ever be bought as low P/E value investments.

Disclosures: Geoff owns NC, CFR, and BWXT

You can learn more about Geoff Gannon by emailing him: [email protected], following him on Twitter: @GeoffGannon, or listening to his podcast

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Geoff Gannon



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Comments

syamee
Syamee premium member - 3 months ago

I always learn a lot from your articles

ney123456789
Ney123456789 - 3 months ago    Report SPAM

Great article... I do have a question. how can a company sustain Operating cash flow higher than earnings for prolong periods of time? should that be registered as part of the earnings? I have seen companies like Omnicom, amazon, etc have done this.

. A cash flow may not be reported as earnings unless it happens at the same time as a sale or expense transaction

so I understand how it could happen in short-term statement, but in the long term?

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