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Footnotes Adjustments for Earnings & Valuation Diligence

Monday, July 1st, 2013

This report summarizes our series of reports on how to convert GAAP data to economic earnings and derive true shareholder value in a discounted cash flow model as well as more accurate values for economic book value, and enterprise value.

Reported earnings don’t tell the whole story of a company’s profits. They are based on accounting rules designed for debt investors, not equity investors, and are manipulated by companies to manage earnings. Only economic earnings provide a complete and unadulterated measure of profitability.

Converting GAAP data into economic earnings should be part of every investor’s diligence process. Meeting the challenge of performing detailed analysis of footnotes and the MD&A is a fiduciary responsibility. Each of the following reports explain each adjustment we make along with how many times we make each adjustment across the 3,000+ companies we cover.

A)    Adjustments for NOPAT: to convert reported GAAP income to net operating profit after tax (NOPAT):

  1. Remove asset write-downs hidden in operating expenses
  2. Remove non-operating expenses hidden in operating earnings
  3. Remove non-operating income hidden in operating earnings
  4. Add back change in reserves
  5. Remove income and loss from discontinued operations (except for REITs)
  6. Add back implied interest for the present value of operating leases
  7. Adjust for non-operating tax expenses
  8. Historical adjustments: Add back goodwill amortization prior to 2002 and include employee stock option expense prior to 2006
  9. Remove reported non-operating items

B)    Adjustments for Invested Capital: to convert reported assets to invested capital (new reports made available daily):

  1. Add back off-balance sheet reserves
  2. Add back off-balance sheet debt due to operating leases
  3. Remove discontinued operations
  4. Remove accumulated Other Comprehensive Income
  5. Add back asset write-downs
  6. Remove deferred compensation assets and liabilities
  7. Remove deferred tax assets and liabilities
  8. Remove under or over funded pensions
  9. Remove excess cash
  10. Prior to 2002: Add back unrecorded and accumulated goodwill
  11. Adjust for midyear acquisitions
  12. Remove non-operating unconsolidated subsidiaries

C)    Adjustments for our Discounted Cash Flow Model, Economic Book Value, and Enterprise Value calculations:

  1. Employee stock option liabilities
  2. Preferred stock
  3. Minority interests
  4. Adjusted total debt (including off-balance sheet debt)
  5. Pension net funded status
  6. Net deferred tax assets or liabilities
  7. Net deferred compensation assets or liabilities
  8. Discontinued operations
  9. Excess cash
  10. Unconsolidated Subsidiaries

We’ve performed unrivaled due diligence on over 55,000 annual reports over the past decade. This diligence enables us to provide unrivaled earnings quality and valuation research.

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3 Comments

  1. varadha says:

    Terrific, yet simple analysis. I’ve always been a fan of ROIC as a measure of capital efficiency and believe that no size/growth outperformance can replace the quest for efficiency.

    Sort of like a big gas guzzling v8 that needs ever increasing gallons of fuel to keep its engine running

  2. David says:

    But Angie’s $90 per user acquisition cost is going to go away. That’s what their approach probably is. How would their outlook be if that $90 cost dropped down to a total cost of $3 per user?

  3. David:

    That would be great, but cost per user acquisition is not something that’s very easy for a company to fix. ANGI can slash their marketing budget to the bone, but then they would stop acquiring new members. They would probably lose members in fact, as their membership renewal rate is at ~75% and declining. If they cut marketing expense by ~95% as you seem to be suggesting, ANGI might be able to eke out 1 year of slight profits, but they would start shedding members and losing money very quickly. ANGI’s only hope is to keep its marketing budget high and hope it can reach the scale and brand awareness to be able to sustain its business while scaling back marketing costs enough to turn a profit. The fact that ANGI’s revenue growth is slowing down even as its marketing costs keep increasing makes it very unlikely it will achieve that goal.

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