Earnings ain't everything, Herb.
I will go out on a limb here and assume that 93% of
readers are sick and tired of stock market punditry given the gyrations of the past week. Even under normal conditions, I have very thin patience for conversations about the future direction of the stock market, and when the interview of the hot-dog salesman across from the
reached my ears, I decided it was time for something completely different.
So I want to try to expand upon
column last week regarding
and the use of cash flow and EBITDA (earnings before debt, interest, taxes, depreciation and amortization) as relevant measures for judging what a company is worth and where it should be trading.
CCE got whacked after a poor quarter, and Herb's point is that using EBITDA and similar measures of cash flow like CCE does is worthless. He says that investors are asking for trouble if they fall for CCE management's assertion that investors should ignore earnings (CCE sells at 90 times earnings), but pay attention to cash flow (CCE sells at
14 times EBITDA). He also mentioned his
on the subject, which goes into further detail.
First off, as Herb's own
column frequently notes, reported earnings can be very easily manipulated through hordes of creative measures. These could include booking receivables in a questionable fashion, moving sales from the next quarter to the current quarter, taking "one-time charges" on a regular basis (which relieves the income statement of earnings-killing expenses), monkeying with tax rates, etc.
Reported earnings are also a poor basis for comparing companies in different industries. Take so-called "core expenses." Drug companies are required to expense their core expense, which is R&D, while
gets to capitalize and then depreciate factory spending, which represents their lifeblood. In fact, many companies within the same industry have very different ways for accounting for expenses, making simple apples-to-apples comparisons sometimes difficult. In fact, it seems that most of the short-sale ideas mentioned in Herb's column correctly focus on the validity of a company's reported earnings.
So the question becomes, If earnings cannot always be taken at face value, what else should we look at to judge a company's performance or to compare valuation for Company A vs. Company B?
Tracking cash flow helps create more of a level playing field by eliminating some "noncash" expenses that a company is forced to take to satisfy GAAP accounting. It also eliminates from valuation and performance comparisons management's choice of how it chooses to capitalize its enterprise --whether debt or equity -- a topic which could make up a whole separate column.
The problem is the measure that many investors use to measure cash flow -- EBITDA -- is flawed.
EBITDA was first developed in the 1980s as a means to sell high-yield bonds on spurious business and leverage assumptions. The advantage of the measure is that it eliminates a number of accounting vagaries when comparing companies in different industries: EBITDA helps adjust for different depreciation schedules, different debt/equity ratios and tax rates, and whether or not companies have made an acquisition via "purchase accounting" or "pooling accounting." Wall Street analysts routinely publish reports with a valuation measure called "enterprise value to EBITDA." Enterprise value is the market value of stock plus net debt, divided by EBITDA. As a rough screen, it has its moments.
The main conceptual hole in EBITDA and where it can be dangerous is the treatment of depreciation -- and this is where I think Herb's criticism was right on target.
A business needs a certain amount of capital each year to run. One can make the broad statement that annual depreciation expense is an estimate of what a company needs to reinvest every year to maintain its business model. Therefore, Company A and Company B could each sell for 10 times EBITDA. But if Company A has to spend $100 million per year in capital expenditures and Company B has to invest only $25 million per year, a "price-to-EBITDA ratio" will completely miss the fact that, all else being equal, Company B is immensely more valuable.
A very simple way to arrive at cash earnings is to:
Start with net income;
Add back amortization of goodwill;
Add after-tax interest expense, for which the formula is: after-tax interest expense times one tax rate, usually 0.36.
This gives you a figure that factors in an implied number for maintenance capital spending because here, unlike with EBITDA, depreciation is deducted as an expense. It also allows a company some benefit for the deductibility of interest expense, which, again, EBITDA does not.
At the least, you can -- and should -- add back goodwill amortization to net income to get a closer look at "cash earnings." In our opinion, goodwill accounting in purchase acquisitions is a complete GAAP accounting fiction that has no bearing on economic reality (for more on this, see
Many companies look different and take very different approaches to accounting and financing issues, and therefore you have to be flexible in what works best. A simple price-to-earnings screen can come up with companies like
(which I discussed
last week) or
. Both of these companies have clean and simple financial statements. In 10 minutes, you can examine 10 years of financial data and come up with a fairly decent value estimate. If you wanted to buy a company like
at 34, you need some different tools.
Lastly, Herb made the comment that CCE's troubles "should be a warning to any investor who invests in capital-intensive companies with high multiples that try to divert attention to EBITDA rather than the bottom line."
I'll buy that as a general concept, but many capital-intensive businesses are highly cyclical (because minor changes in the economic environment wreak havoc on a company with a high break-even point) that should be bought when the price-to-earnings ratio is either nonexistent or sky high. Why? You should be buying somewhere near an earnings trough, rather than paying seven times earnings at an earnings peak.
And while a lot of this may seem overly complicated -- and you can just buy Coca-Cola Enterprises and go away -- this is exactly the kind of financial exercise CCE management employs. It just makes it look easy.
Jeffrey Bronchick is a portfolio manager and principal with the investment firm Reed Conner & Birdwell. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. At the time of publication, he holds positions in Dionex and Abbott Labs, although these holdings can change at any time. Birdwell is based in Los Angeles and manages about $1 billion of assets for institutions and taxable individuals. Bronchick's column, The Buysider, appears every Tuesday on