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1 October 2013

Footnotes Adjustments for Earnings & Valuation Diligence


This report summarizes our series of reports on how to protect your portfolio from blow-ups. We detail all the red flags and hidden items buried deeply in SEC disclosures that we use to provide a more accurate measure of cash flow and valuation. There is no substitute for our unrivaled diligence.

Reported earnings don’t tell the whole story of a company’s profits. They are based on accounting rules originally designed for debt investors, not equity investors, and are often manipulated by companies to manage earnings. As a former accountant and current member of FASB’s Investor Advisory Committee, I know first hand that accounting regulators are working to address these challenges - details here. In the meantime, investors need to do their own diligence.

Finance 101: Only economic earnings that incorporate due diligence in the financial footnotes provide a complete and unadulterated measure of profitability.

Converting GAAP data into economic earnings should be part of every investor’s diligence process. We provide this diligence to our clients by converting GAAP data to economic earnings and deriving true shareholder value in a discounted cash flow model as well as more accurate measures of economic book value, and enterprise value.

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. This includes foreign currency exchange losses 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 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 ModelEconomic 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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