Why Footnotes Matter
Hidden items lurking in the financial footnotes can dramatically impact a company's yearly profitability.
Andre Rouillard
Footnotes Adjustments
Andre Rouillard
NOPAT Adjustment: Foreign Exchange Loss
Converting GAAP data into economic earnings should be part of every investor’s diligence process. Performing detailed analysis of footnotes and the MD&A is part of fulfilling fiduciary responsibilities.
David Trainer, Founder & CEO
30+ Accounting Adjustments to Get the Truth About Earnings & Valuation
Reported earnings don’t tell the whole story of a company’s profits. They are frequently manipulated by companies to manage earnings.
David Trainer, Founder & CEO
Unconsolidated Subsidiary Assets – Valuation Adjustment
Investors who ignore unconsolidated subsidiary assets are not getting a true picture of the cash available to be returned to shareholders. By adding unconsolidated subsidiary assets one can better understand the value of the stock to shareholders. Diligence pays.
David Trainer, Founder & CEO
Non-Operating Unconsolidated Subsidiaries—Invested Capital Adjustment
This report is one of a series on the adjustments we make to convert GAAP data to economic earnings. This report focuses on an adjustment we make to convert the reported balance sheet assets into invested capital.
David Trainer, Founder & CEO
Midyear Acquisitions – Invested Capital Adjustment
When a company makes an acquisition, the entire purchase price is added to the company’s balance sheet in the year of the acquisition along with any assumed debts or other long-term liabilities. However, the only income added to the income statement is that which occurs after the acquisition closes. In other words, the balance sheet is charged with the full price of the acquisition while the income statement only gets partially impacted.
David Trainer, Founder & CEO
Reported Net Non-Operating Items – NOPAT Adjustment
Income statement adjustments include financing items like interest expense/income, preferred dividends and minority interest income. These items are related to the financing of a company’s operations, not the operations themselves. We always calculate NOPAT on an unlevered basis.
David Trainer, Founder & CEO
Excess Cash – Valuation Adjustment
For most companies, we estimate the required amount of cash for normal business operations to be around 5% of sales. However, many companies hold cash or other liquid investments above and beyond this amount. We refer to this extra amount as excess cash. This surplus cash can be used for any number of purposes, including acquisitions, research and development, and cushioning the company against economic downturns. Excess cash is immediately available for distribution to shareholders, so we add a company’s excess cash to our calculation of shareholder value.
David Trainer, Founder & CEO
Discontinued Operations – Valuation Adjustment
There is one last adjustment we must make involving discontinued operations: adding net assets from discontinued operations to shareholder value. Because discontinued operations are parts of a company being held for sale, the value of the net assets from these discontinued operations approximate the cash the company will receive from the sale. This cash will then be available for distribution to shareholders.
David Trainer, Founder & CEO
Deferred Compensation Assets and Liabilities – Valuation Adjustment
The net amount of deferred compensation is included in shareholder value. If a company has a net liability, future cash flows will be diverted to pay for that obligation. If a company has a net asset, then any future increases in the obligation will not need to be met with new contributions from the company. Instead, the company can return that cash to shareholders.
David Trainer, Founder & CEO
Net Deferred Tax Assets and Liabilities – Valuation Adjustment
We subtract net deferred tax liabilities (DTLs minus DTAs) from our calculation of shareholder value as they are real future cash obligations that limit the amount of money available for distribution to shareholders.
David Trainer, Founder & CEO
Pension Net Funded Status – Valuation Adjustment
Companies with underfunded pensions will likely need to divert a greater amount of future cash flows away from shareholders to make up the funding gap. An accurate analysis of shareholder value should include the net funded status of pensions.
David Trainer, Founder & CEO
Adjusted Total Debt – Valuation Adjustment
The fair value of a company’s total debt is the current amount the company would need to pay to retire the debt and settle the claims of the creditors. This fair value of debt is subtracted from shareholder value because the firm would need to settle these claims before it could return any cash to shareholders.
David Trainer, Founder & CEO
Minority Interests – Valuation Adjustment
We subtract the fair value of the minority interest liability from shareholder value in our DCF model as the minority interest shareholders have the rights to that portion of the cash flows. Without careful research, investors would never know that these minority interest liabilities distort GAAP numbers.
David Trainer, Founder & CEO
Preferred Stock – Valuation Adjustment
Preferred stock is a hybrid instrument that carries no voting rights but has a senior claim on assets and cash flows to common stock. Dividends usually must be paid out to preferred stock owners before common stock owners can receive any money. In the event of liquidation, preferred shareholders also have priority.
David Trainer, Founder & CEO
Outstanding Employee Stock Options – Valuation Adjustment
Without careful footnotes research, investors would never know the amount of employee stock options that decrease the amount of future cash flow available to shareholders by diluting the value of existing shares.
David Trainer, Founder & CEO
Accumulated Goodwill Amortization and Unrecorded Goodwill – NOPAT Adjustment
Converting GAAP data into economic earnings should be part of every investor’s diligence process. Performing detailed analysis of footnotes and the MD&A is part of fulfilling fiduciary responsibilities.
David Trainer, Founder & CEO
Excess Cash – Invested Capital Adjustment
Most companies hold some cash—or cash equivalents in the form of investments—above this required amount. Companies hold excess cash in order to cushion against economic downturns, prepare for acquisitions, or any number of other reasons. Sometimes, past profits pile up on balance sheets and are a form of excess cash. Excess cash is not needed for the operations of a company. It is removed from our calculation of invested capital.
David Trainer, Founder & CEO
Overfunded Pension Plan Assets – Invested Capital Adjustment
Overfunded pension assets are similar to excess cash, and should not be included in the calculation of return on invested capital (ROIC).
David Trainer, Founder & CEO
Deferred Tax Assets and Liabilities – Invested Capital Adjustment
DTAs artificially raise reported assets and do not help generate operating profit while DTLs are like a source of interest-free financing. We remove the impact of DTAs and DTLs from our calculation of invested capital to ensure the more accurate measure of a firm’s return on invested capital (ROIC).
David Trainer, Founder & CEO