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Balance sheet adjustments

    • Book value may be overstated by intangible assets or understated by land or stock investments that have appreciated, but are carried on balance sheet at cost. Remove goodwill from book value.
    • Don’t take asset values on balance sheet at face value
      1. The figures for assets in the balance sheet can be misleading. Things like real estate, machinery and other equipment and inventory may not be worth as much as the company claims, especially if they are outdated. Real estate carried on the books at historical purchase price might also have declined or increase in value. For a retailer, the reliability of the inventory figure depends on the kind of products it sells, e.g. clothes may go out of style, but seedlings and trees are likely to have resale value.
      2. It is difficult to know whether a company’s goodwill is really worth that much. Be wary of the asset value (& thus equity value and book value) of a company if a high percentage of assets is made up of goodwill.
    • For cash accounts, there is no adjustment needed as they are marked-to-market and represent fair value.
    • As for accounts receivable, the rule is to add bad debt allowances and adjust for collections to get a realistic value of accounts receivable.
    • Inventory is valued at FIFO basis and if the firm is using LIFO, then add LIFO reserve to the balance sheet number.
    • With Property, Plant & Equipment, the adjustment is made on case-by-case bases, but the general adjustment is made with the original cost plus any adjustments such as previous comparable sales of similar PPE.
    • When working with intangibles or goodwill, there is no adjustment number as intangibles or goodwill is based on the product portfolio and research and development. Since there is no replacement cost, I can use one of three ways to figure out a conservative book value estimate: (1) is to look at previous deals of a similar brand and see the acquisition price, (2)could also add up the costs of R&D spending attributable to the product or brand created from conception to deliverable or (3) add up the costs of three years worth of marketing and sales expenditures.
    • As for deferred taxes, if the company is going to have a profitable year, perform a discount to present value calculation on the cash to be paid in the future for taxes or if the company is going to generate losses, push the payment further out into the future and do a discount to present value calculation as well.
    • Lastly, for long term liabilities, there is no calculation to be done as it is marked at book value, unless otherwise, account for any new issues of debt. Then take the total liabilities and subtract from total assets and I get reproduction cost or reproduction value.

PNL adjustments

Purpose of PNL adjustment: Adjusted EBIT removes non-recurring and non-operating gains and losses, accounting distortions and reclassifying some expenses as investments (capitalizing them to balance sheet) etc.

    • Amortization expense overstating a company’s cost and after full amortization, the year after will get a boost in earnings due to the benefit of expiration of amortization charge leading to lower expenses.
      1. Amortization expense may overstate the company’s actual costs, especially given its acquisitive nature. With software, for example, amortization charges are very real expenses. Charges against other intangibles such as the amortization of customer relationships, however, arise through purchase-accounting rules and are clearly not real costs. GAAP accounting draws no distinction between the two types of charges. Both, that is, are recorded as expenses when earnings are calculated — even though from an investor’s viewpoint they could not be more different. Eventually, of course, the non-real charges disappear when the assets to which they’re related become fully amortized. But this usually takes 15 years and — alas — it will be my successor whose reported earnings get the benefit of their expiration.
    • Stock options not being fully expensed
      1. Accounting treatment for stock options is flawed (at least in the US). The accounting convention in US was that, provided employees were first given options, required that when easily marketable stock was issued to employees at below-market price, the bargain element for the employee, although roughly equivalent to cash, could not count as compensation expense in determining a company’s reported profits. However when paying income tax, the bargain element in stock option exercises is treated as an obvious compensation expense, deductible in determining income for tax purposes. Today, GAAP requires some part of the real cost of employee stock options to be recorded as an expense in the income statement, but Charlie remains skeptical as by the time stock options are exercised, the total cost charged is usually far less than the total cost incurred. Moreover, the part of the cost that is charged to earnings is often manipulated downward by dubious techniques. The right way to behave is to never let improper accounting begin.
      2. most companies also have liberal stock option plans and management could always explain that a moderation small shift toward compensation in option-exercise form was needed to help attract or retain employees.
      3. By substituting employee cash incentive bonus with employee stock option exercise profits, and using bonus money saved plus option prices paid to buy back all the shares issued in option exercises and keeping all else the same, the result would be to drive reported earnings up by the “savings”, while shares outstanding remained exactly the same. The plot would be to add to real earnings an element of phony earnings (phony since the company would enjoy no true favorable economic effect except for temporary fraud-type effect similar to that of over-counting closing inventory).
    • Need to adjust EBIT as there is still potential distorting effects when companies use differing methods in accounting for fixed assets.
    • EBIT itself is also a short-hand measure of sorts in that, without further adjustment, it assumes that a company’s expense for depreciation and amortization is equal to its expense for maintenance capital expenditures (capex). This assumption can distort a business’s true earnings yield and the comparison of its earnings yield to that of other businesses. The growth portion of capex in a growing business may materially understate EBIT if a distinction is not made between growth capex and maintenance capex. To get a more accurate view of a business, you should calculate EBIT by subtracting actual maintenance capex from EBITDA. If a business does not disclose its maintenance capex, you can usually derive it by making some reasonable assumptions.

Differences between variations of earnings

Operating income (similarly to EBIT and often used interchangeably, but not the same)

  • Operating income reflects the a company’s profits from its usual business activities, before deducting interest expenses or taxes.
  • Operating Income = Revenue – COGS – SG&A (Operating expenses) – Depreciation & Amortization
  • Doesn’t take into account taxes, interest, non-recurring, and non-operating gains and expenses


  • Takes into account non-operating income and non-recurring income – you have to pay taxes on them.
  • When normalizing/adjusting the EBIT, non-recurring and non-operating income and expenses should be removed from EBIT. After this, both EBIT and Operating Income should provide the same figure. Hence the interchangeable nature of these 2 terms.

Net income/net profits/net earnings/bottom line

  • EBIT – Interest – Taxes

NOPAT (net operating profit after tax)

A longer way of calculating NOPAT:

  • NOPAT = Adjusted EBIT * (1 – Tax Rate)
  • Adjusted EBIT removes non-recurring and non-operating gains and losses, accounting distortions and reclassifying some expenses as investments (capitalizing them to balance sheet) etc.
  • NOPAT value shouldn’t include one-time losses and other non-recurring charges because they don’t represent the true, on-going profitability of the business.
  • The equivalent of net profit (after minusing taxes), removing the effects of non-recurring and non-operating gains and losses, effect of interest payments due to debt, effect of tax savings due to interest payments.
  • NOPAT uses adjusted EBIT (remove non-recurring and non-operating gains and losses) because it doesn’t take interest payments into account.
  • NOPAT shows a company’s potential cash earnings if its capitalization were unleveraged i.e., if it had no debt and doesn’t need to pay interest. NOPAT is a more accurate look at operating efficiency for leveraged companies.
  • It is a measure of profit that excludes the costs and tax benefits of debt financing. It does not include the tax savings many companies get because they have existing debt. You can’t just take EBIT and plus back taxes, without taking into account the tax savings from interest payments.
  • Compare to companies within the industry to determine if it is high or low.

NOPLAT (Net operating profit less adjusted taxes)

  • NOPLAT refers to total operating profits for a firm with adjustments made for taxes. It represents the profits generated from a company’s core operations after subtracting the income taxes related to the core operations. NOPLAT is often used as an input in creating discounted cash flow valuation models.
  • Used in preference to Net Income as it removes the effects of capital structure (debt vs. equity). The Operating Profit is prior to interest and taxes being subtracted, which makes NOPLAT equal NOPAT.
  • The NOPLAT is used in a variant of the FCF used in Mergers and acquisitions.
  • NOPLAT = Net Operating Profit less adjusted taxes = Unlevered net income + Change in deferred taxes
  • Unlevered Net Income = Net Income + Net Interest after tax (I*(1-t))
  • This comes into play when your NCC (non-cash charges) include deferred taxes. These taxes were not actually paid out, thus it’s an add-back. If there are no deferred taxes, then NOPAT = NOPLAT

Skill in investing retained earnings

Importance of effectiveness of management in its use of retained capital:

  • The ability to use retained earnings wisely is a sign of good company management.
  • If you can purchase a company with a durable competitive advantage at the right price, the retained earnings of the business will continuously increase the underlying value of the business and the market will continuously ratchet up the price of the company’s stock (depending on what use are they put to, and the subsequent level of earnings produced by that usage).
  • Accumulating too much retained earnings can prove detrimental to shareholder value. If retained earnings are left unutilised, they can pile up as cash reserves that hardly earn any return. Moreover, it is not the utilization but effective utilization of reserves that is necessary for creating value.

Timing of translation of retained earnings into realized and unrealized capital gains:

  • Translation of retained earnings into corresponding realized and unrealized capital gains (due to market price appreciation) will be extremely irregular as to time of occurrence. While market values track business values quite well over long periods, in any given year the relationship can gyrate capriciously.
  • Market recognition of retained earnings also will be unevenly realized among companies.  It will be disappointingly low or negative in cases where earnings are employed non-productively. Market recognition of retained earnings will be far greater than dollar-for-dollar of retained earnings in cases of companies that achieve high returns with their augmented capital.
  • When purchase prices are sensible, some long-term market recognition of the accumulation of retained earnings almost certainly will occur.  Periodically you even will receive some frosting on the cake, with market appreciation far exceeding post-purchase retained earnings.

How to determine if management skillfully invested retained earnings:

  • A good usage of retained earnings is when a company repurchase their own shares. Share buybacks comes price appreciation. Buffett likes companies that have buybacks regularly instead of occasionally.
  • The test for Warren Buffett is whether company management can transform each dollar of earnings retained into no less than a dollar of market value. The period he uses is 5 years (on a rolling basis). I.e. for a 5 year period, if $x is retained in total, then the price of the stock should have increased by the same amount now vs 5 years ago. Measure how much market value has been added by the company’s retention of capital.
    • Suppose shares of Company A were trading at $10 in 2002, and in 2012 they traded at $20. Thus, $5.50 per share of retained capital produced $10 per share of increased market value. In other words, for every $1 retained by management, $1.82 ($10 divided by $5.50) of market value was created.
    • The downside to this test is: When the stock market is valued at an extremely high valuation (which often happen for long stretches of time at once) and has declined sharply over a five-year stretch, the market-price premium to book value will shrink from the peak of the bubble. And when that happens, a great management will fail the test if they had the misfortune of taking over near the peak of a bubble in their company’s stock valuation. Just as it is difficult to evaluate the performance of these CEOs over the past decade based on share price performance alone, it is difficult to evaluate the wisdom of earnings retention using the same standard.
  • The five-year test should be the following 2 points. If these tests are met, retaining earnings has made sense.
    • (1) during the period did the company’s book-value gain per share exceed the performance of the S&P over a 5-year rolling basis?
      • Shouldn’t it be (book value gain per share as a % of retained earnings per share)? Need to take into account how much is retained since the more you retain the more the increase in book value should be.
    • (2) did the stock consistently sell at a premium to book? I.e. price to book ratio of at least 1 consistently. This means that every $1 of retained earnings was always worth more than $1 since $1 of retained earnings goes in asset as cash or investment in plants etc. and a good investment of retained earnings ensures that the value of this retained earnings won’t shrink.
    • Drawbacks to this test:
      • Book value is only a rough proxy of changes in intrinsic value.
        • None of a private subsidiary’s increase in market value will be reflected in a parent’s book value because it is not mark to market and thus comparable public companies might see a 200% increase in market cap while a private subsidiary’s value only changes by the amount of retained earnings within the business.
        • There are many accounting distortions that have an impact in lowering book value, which have no impact on intrinsic value, widening the gap between the two.
      • Overall price to book value ratio does not measure the wisdom of retention of incremental capital.  It is perfectly possible to have value destroying earnings retention coincide with maintenance of a price to book value ratio well in excess of 1.0 because of the cumulative effect of decades of good decisions that have created the bulk of the intrinsic value.  At the margin, earnings retention could still destroy value while the price to book ratio remains above 1.0, although below what it otherwise might have been without earnings retention.
  • Return on retained earnings (RRE). Look at how retained earnings is used to maintain the durable competitive advantage. The idea is to take the amount of retained earnings by a business for 10 years and measure its effects on the business’ earnings capacity. Simply compare the total amount of profit per share retained by a company over a given period of time against the change in profit per share over that same period of time.
    • For example, if Company A earns 25 cents a share in 2002 and $1.35 a share in 2012, then per-share earnings rose by $1.10. From 2002 through 2012, Company A earned a total of $7.50 per share. Of the $7.50, Company A paid out $2 in dividends, and therefore had a retained earnings of $5.50 a share. Since the company’s earnings per share in 2012 is $1.35, we know the $5.50 in retained earnings produced $1.10 in additional income for 2012. Company A’s management earned a return of 20% ($1.10 divided by $5.50) in 2012 on the $5.50 a share in retained earnings.
    • For Buffett, the minimum acceptable return is 12% over a period of 10 years. If the return is greater than or equal to 12%, Buffett considers such companies as efficient in managing retained earnings. On the other hand, if the return is less than 12%, the companies are considered inefficient in managing retained earnings.
    • Return on retained earnings should be higher than industry average and general market.
  • Look at ROIC
    • Objective metric which measures the pace and rate at which how much $1.00 re-invested can produce back in earnings.
    • Calculate each year going back 5-10 years and look for a pretty stable and usually earns about 20% on invested capital (both from equity and debt).
    • Ensure low debt to equity ratio as high debt implies that shareholder equity is not enough to fund growth and creditors have a greater claim on the business than the owners.
    • Use net operating profit because it excludes the non-reoccurring and extraordinary items so you’re left with the real meat of its earnings.

Problems with defining rules for determining effectiveness of retained earnings:

  • It is unwise to examine the past 5 years (or 10 years) outside the context of the extraordinary macroeconomic environment that has prevailed throughout the period.
  • The problem with attempting to define a type of rule is that some element of management judgment is always going to be required when deciding on earnings retention policy.  Only after a period of time passes will shareholders be able to evaluate whether the retained earnings created value or not  Shareholders must trust management judgement (should management fail the tests) based on their cumulative history at the company and are willing to grant a huge amount of latitude based simply on the track record.
  • The retained earnings test might be better formulated to incorporate a company’s performance relative to the S&P 500 over a full market cycle.