Cashing In on Paychex Power

In my debut column I used a case study of wealth sinkhole Enron to show how you might be tricked into thinking a firm's financial performance is more robust than perhaps it really is.

For contrast, let's look today at Paychex (PAYX - commentary - Cramer's Take), a company with authentic earnings power. How can you tell the difference?

Essentially, it lies in the four substantive limitations of the accrual income statement. To review, these limitations are:

The omission of investment in fixed capital.

The omission of investment in working capital.

The immediate expensing of intangible growth-producing initiatives such as research and development, marketing and advertising, and employee education.

Shareholders' equity is "free."

As a result, a firm may appear profitable in the traditional (i.e., accrual) sense of the word, even though it is unable to self-fund and/or create value. These limitations can cost you money or time -- or both. Fortunately, they can be fixed. But to do so, we must create two alternate income statements. Yes, this requires effort, but it will probably save you from making big mistakes.

Collecting Paychex

Like Enron, Paychex's accrual profits grew at a smart clip during the 1990s. Crucially, however, the payroll services provider also made money the way that defensive and enterprising investors think about making money. Not only was Paychex getting bigger -- it was getting better.

These Earnings Are Real As Paychex's profits grew, their quality improved

Source: Company reports, EarningsPower.com

Both Enron and Paychex were "in the black" accrual-wise, but only one had really real profits. What explains this discrepancy?

Paychex's four substantive limitations, as we see below, totaled 1.4% of sales. Enron's limitations, however, accounted for 5.6% of sales. These additional charges as a percentage of sales may not sound like a lot, but they turned the energy trader's accrual profits into defensive and enterprising losses. That's the difference between sugar in your candy and sugar in your soup.

I use an x-y scatter chart to view the relationship between a company's defensive profit and enterprising profit. The two are not the same, and both are essential to having authentic earnings power. What I'm looking for is a company that is situated in the upper-right box, or what I call the Earnings Power Box. Companies in that quadrant are able to self-fund and create value. They're the best companies to own, especially for the long run (provided, of course, the valuation is reasonable).

Paychex was in the Earnings Power Box during most of the 1990s. Even more extraordinary, the company forged what I call an Earnings Power Staircase, so named because the x-y scatter chart looks like the profile of a staircase. (In this analogy, the "rise" is the incremental increase in defensive profits, while the "run" is the periodic change in enterprising profits.) Paychex's staircase pattern explains why the stock appreciated 2,911% between the beginning of 1990 and the end of 1999. Truly, Paychex was the closest thing on Wall Street to a gold mine.

Thinking Inside the Box Paychex spent most of the '90s in the Earnings Power Box

Source: Company reports, EarningsPower.com

Soft Serve

Microsoft (MSFT - commentary - Cramer's Take) is another company that forged a staircase during the 1990s, as we see below. If you bought Microsoft stock at the beginning of 1990 at a split-adjusted $1.23 and sold at the end of 1999 at $116.75, then you made a 9,371% return. Even if you still own the shares at their recent price of $52, then you're up 4,119%.

Redmond's Rise How the Microsoft juggernaut plays out on an X-Y chart

Source: Company Reports, EarningsPower.com

For many of you, this history lesson may be interesting, but you really want to know how Microsoft's doing now. Stay tuned. In future columns, I'll look at the recent quality-of-earnings performance for this and other popular tech (and non-tech) companies.

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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].