The Earnings Power Glossary

Here are a few definitions that will help you learn more about the Earnings Power model that I'll be discussing in future columns. For a further illustration of the model, please refer to these columns.

Accrual income statement: The profit-and-loss found in every annual report, 10-K and 10-Q. It's so named because it follows the principles of accrual accounting.

Accrual accounting: The governing principles for financial statements filed with the Securities and Exchange Commission. A goal of accrual accounting is to match current sales with current expenses and future sales with future expenses. A notable exception to this rule, however, is the treatment for intangible growth-producing initiatives, which are immediately expensed.

Accrual profits: The proverbial bottom line in the accrual income statement. Crucially, however, just because a company is profitable the way accountants define profits doesn't mean that it has authentic earnings power. This is because the accrual P&L has four substantive limitations. As a result, a company may be profitable in the traditional sense of the word even though it is unable to self-fund and create value.

Capital: Includes the book (i.e., accrual) value of interest-bearing debt, preferred stock and shareholders' equity, as well as deferred taxes, capitalized operating leases, reserves, net capitalized intangibles, cumulative goodwill amortization, unrecorded goodwill, cumulative unusual (gains) or losses after-tax, cumulative extraordinary (gains) or losses after-tax and (non-operating cash and marketable securities).

Cost of capital: The estimated interest rate that a firm pays in cash and opportunity costs to induce lenders and owners to finance, or "capitalize," its operations. In the enterprising income statement, a firm's interest rate is equal to the product of its cost of capital and the average of two years' worth of capital. Most profitable, large-cap firms have a cost of capital of 8% to 10%.

Create value: A company creates value when it produces a return on capital that is greater than its cost of capital. For example, if a company earns 12% on capital and its cost is 10%, then it has created value. On the other hand, if the company earns 8%, then value has been destroyed. Companies that destroy value waste their owners' time. To test whether a firm is creating value, use the enterprising income statement.

Debt repayment period: The period of time, in years, that a firm needs to repay net debt (debt plus capitalized operating leases, less cash and marketable securities) based on the last four quarters' worth of enterprise defensive profits. The lower a firm's DRP, the better.

Defensive income statement: This alternate P&L is unique in that investment in fixed and working capital is expensed when incurred.

Defensive investor: The chief aim of the defensive investor is to avoid committing "serious mistakes or losses." Has a personality like a commercial banker, whose motto is "safety first." Likes companies that can self-fund; i.e., produce more free cash flow from ongoing operations than they consume. The defensive investor uses the defensive income statement.

Earnings power: A company has authentic earnings power when it is profitable the way defensive and enterprising investors calculate profits. This is key: Just because a company's per-share accrual profits keep rising from one year to the next does not mean that it automatically has earnings power.

Earnings Power Box: The upper-right box of a four-box, x-y scatter chart that you learned about in eighth-grade math class. The y (vertical) axis of the scatter chart is defensive profit or loss; the horizontal (x) axis is enterprising profit or loss. The best companies to own, especially for the long haul, are situated in the Earnings Power Box. This is because EPB companies are able to self-fund and create value.

Enterprise defensive profits: The sum of defensive profits plus bank interest and the implied interest on capitalized operating leases. The prefix "enterprise" here refers to the combined interests of lenders and owners, and is not to be confused with the enterprising income statement.

Enterprise value: Market value plus debt, less cash and marketable securities. The prefix "enterprise" here refers to the combined interests of lenders and owners, and is not to be confused with the enterprising income statement.

Enterprising income statement: This alternate P&L is unique in two respects. First, intangible growth-producing initiatitives are converted from operating expenses to capital assets (which enables apples-to-apples comparisons of hard-asset companies with soft-asset firms in "mind-based" industries like drugs, software and technology). Second, the book value of shareholders' equity is expensed, typically at a 10% rate.

Enterprise value-to-enterprise defensive profits: (Market value plus debt, minus cash, minus marketable securities) divided by (defensive profits, plus interest, minus interest tax benefit). The lower the multiple, the more out-of-favor the company's stock, but also the bigger your cash-on-cash return.

Enterprising investor: The primary goal of the enterprising investor is to own companies "more attractive than average." To make sure a company meets this criterion, the enterprising investor uses the enterprising income statement, which gauges whether a firm is creating value.

Four substantive limitations: The accrual income statement found in every annual report, 10-K and 10-Q has four substantive limitations: (1) omits investment in fixed capital, (2) omits investment in working capital, (3) intangible growth-producing initiatives are immediately expensed and (4) shareholders' equity is "free." As a result, a company may appear profitable in the traditional (i.e., accrual) sense of the word even though it is unable to self-fund and create value.

Investment fixed capital: Capital spending (including cash paid for acquisitions) less depreciation. Both amounts are reported in the statement of cash flows. The defensive income statement immediately expenses this outlay dollar-for-dollar when incurred because it is a use of cash.

Investment in working capital: The increase or decrease in working capital from one period to the next. The defensive income statement expenses this outlay dollar-for-dollar when incurred because it is a use of cash.

Intangible growth-producing initiatives: Covers things like research and development, marketing and advertising, and employee education. The enterprising income statement converts intangibles from operating expenses to capital assets and then depreciates them over an appropriate period. As a result, current sales are matched with current expenses and future sales are matched with future expenses.

Market value: Stock price multiplied by shares outstanding.

Opportunity cost: Shareholders are not obligated to receive any particular rate of return when they buy a stock. However, companies must produce a reasonable return on the book value of shareholders' equity; otherwise investors will sell their stock and the firm's market value will fall. Also known as the cost of equity.

Self-fund: A company can self-fund when it produces more cash from ongoing operations than it consumes. Companies that can self-fund are able to pay bank interest, reduce debt, buy back shares and invest for future growth. To determine whether a firm can self-fund, use the defensive income statement, which expenses investment in fixed and working capital dollar-for-dollar when incurred because they are uses of cash.

Shareholders' equity is free. All companies are financed, or "capitalized," with a mixture of debt and equity capital. The cost of debt capital is recorded as an expense in the accrual income statement because it is a use of cash. In contrast, there is no line item for the cost of equity capital (even though it is an opportunity cost). Thus, companies that employ substantial amounts of equity capital to finance their business may not be as profitable as they appear in the accrual and defensive income statements.

Staircase: The ability to consistently increase defensive and enterprising profits every year, a hallmark of a great company. When you view this performance on an x-y scatter chart, the pattern resembles the profile of a staircase. (Think of the incremental increase in defensive profits as the rise in the staircase, and the periodic change in enterprising profits as the run.)

Working capital: The difference between working capital assets like receivables, inventory and prepaid expenses minus payables and accrued liabilities.

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Hewitt Heiserman has been a financial analyst for 15 years and has worked for Fidelity Investments, Simplex Time Recorder, American Holdco and Breakaway Solutions. He is now writing a book on the Earnings Power Box, an analytical model he created to gauge the quality of a firm's profits. (The Earnings Power Box is a trademark of Hewitt Heiserman.) At the time of publication, Heiserman had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback and invites you to send it to [e-mail].