Of Gold Mines and Sinkholes

Editor's Note: We're pleased to introduce our newest contributor, Hewitt Heiserman. A longtime financial analyst, 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. We hope you enjoy the column; as always, let us know what you think.

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Dot-com bombs. Nasdaq crash. Earnings management. Insider trading. Hidden debt. Recurring "one-time" charges. Accounting fraud. Analyst double-speak. Auditor indictments. Incompetent directors. Large-caps going bankrupt.

No question about it, the past couple of years have roughed up many investors. You too? What are you doing about it? Are you pulling the covers over your head and pretending it was all a bad dream? Or are you learning from your mistakes and improving your game?

One lesson is the importance of constantly improving our analytical skills. For the past several years, I've kept a file of helpful ratios and research methodologies gleaned from other RealMoney columnists on topics ranging from auditors to the Z-score. When I have a few minutes, I add new calculations from these columns to my due diligence checklist. The way I see it, whoever has the best spreadsheet wins.

This leads me to a pet theory: The riskiest stocks to own are growth stocks. Here's why. First, it's human nature to let your guard down when a company's share price keeps rising. Second, even the bluest of blue-chips can sear a hole in your wallet if you overpay (which, admittedly, is always more obvious in hindsight). Third, just because a company is profitable the way accountants think about profits doesn't mean that it has authentic earnings power.

This is because the income statement in every annual report, 10-K and 10-Q, has four substantive limitations:

It omits investment in fixed capital.

It omits investment in working capital.

It expenses intangible growth-producing initiatives.

Shareholders' equity is free.

So how can you protect yourself?

What I do is gauge a firm's quality of earnings from opposing viewpoints. I got this idea from Benjamin Graham, who writes in The Intelligent Investor, that there are two types of investors: Defensive and enterprising. According to Graham, the chief aim of the defensive investor is to avoid committing "serious mistakes or losses," while the primary goal of the enterprising investor is to own companies "more attractive than average."

In other words, the defensive investor is like the commercial banker whose motto is "safety first," while the enterprising investor is closer to the venture capitalist who thinks about growth for tomorrow. Unfortunately, due to the aforementioned limitations, the accrual income statement fails to meet the needs of either personality type.

To test whether a firm is profitable from the defensive investor's perspective, I create a "defensive" income statement. This model expenses investment in fixed and working capital in the year incurred. A company makes an investment in fixed capital when its capital spending (including cash paid for acquisitions) is greater than its depreciation charge. It makes an investment in working capital when working capital -- receivables, inventory and prepaid expenses minus payables and accrued liabilities -- increase from one year to the next.

If a company has a defensive profit, it's able to self-fund its growth via internally generated free cash flow. Companies with defensive losses, on the other hand, are at risk of going bankrupt, especially if the losses continue for any length of time. That can cost you money.

To check results from the enterprising investor's perspective, I create a second alternate P&L, an "enterprising" income statement. This model converts intangibles from operating expenses to capital assets, and then depreciates them over their useful life (an educated guess, to be sure). As a result, I can make apples-to-apples comparisons of hard-asset companies with soft-asset firms in "mind-based" industries like drugs, software and technology.

The other unique aspect of the enterprising income statement is that the book value of shareholders' equity is expensed, typically at a minimum rate of 10%. Adding a line for the opportunity cost of owner financing reminds me that it has a cost, even if it is a noncash cost. If a company is profitable after these two adjustments, then it is creating value for shareholders. Companies with enterprising losses, on the other hand, mean owners' time is being wasted.

In summary, the defensive income statement fixes limitations No. 1 and No. 2 of the accrual ledger, while the enterprising income statement fixes limitations No. 3 and No. 4.

Let's examine Enron, a company that appeared to have earnings power but really didn't. For the three years ended Dec. 31, 2000, per-share accrual profits for the energy trader were as follows:

1998: 99 cents

1999: $1.08

2000: $1.10

If, however, we ran Enron's numbers for 2000 through the defensive income statement, it actually lost money to the tune of $3.4 billion, or $4.17 a share. Most of this red ink is due to a $2.4 billion investment in fixed capital and another $1.1 billion investment in working capital.

Meanwhile, according to the enterprising income statement, the firm lost $1.3 billion, or $1.49 per share. This deficit is principally due to $2.1 billion of interest, a calculation that takes into account the cost of all capital that's been invested in the business, including equity capital. (Note: These numbers are from its original 10-K, which has since been discredited.)

Let's take another look at Enron's quality of profits for the three years ending Dec. 31, 2000. Even if you don't have a degree in finance, it's clear this company was in bad shape going back to at least 1998. (It confounds me that Enron's peak market value was $73 billion.)

Source: Company reports; EarningsPower.com

We finish our post-mortem by viewing Enron's performance through the gimlet eye of the Earnings Power Box, or EPB. I created this x-y scatter chart several years ago to protect myself from buying companies that appeared to have earnings power but really didn't. Defensive profit (loss) is plotted on the y (vertical) axis; enterprising profit (loss) goes on the x (horizontal) axis.

According to the EPB, the best companies to own, especially for the long haul, are situated in the upper right, or earnings power, box. These companies are able to self-fund and create value; i.e., they are profitable the way defensive and enterprising investors think about profits.

The worst companies, on the other hand, are situated in the lower left box -- even if they have accrual profits! The untold story of Enron circa late-'90s is that it was right there in the lower left for everyone to see.

Source: Company reports; EarningsPower.com

Oh, by the way, do you know how management described 2000? Here is an excerpt from that year's letter to shareholders:

Enron's performance in 2000 was a success by any measure. The company's net income reached a record in 2000. Enron is laser-focused on earnings per share, and we expect to continue strong earnings performance.

(For additional information on these concepts, check out EarningsPower.com.)

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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].