Why Some Earnings Are Different Than Other Earnings (One tool in the toolkit of finding undervalued stocks)

Gretchen Morgenson of the New York Times (a terrific business journalist who I cannot heap enough accolades on) has a short but very useful report on judging different corporations earnings.  And yes, sometimes two companies may have the same Earnings Per Share (EPS) but if we "read between the lines" the earnings are not the same.

Morgenson spends a great deal of this report picking the brains of a Mr. Robert A. Olstein.  Beginning in 1995 Olstein has managed a fund which has usually outperformed the S & P 500 Index by about 3.25% after fees.  Like many other money managers, Mr. Olstein's results were not very good in 2008.  But he still holds to the same core strategy, and maybe even doubled his efforts.  Morgenson quotes Olstein "As the market goes higher, it becomes more important to measure the quality of corporate earnings," Olstein said. "You have to look behind the numbers."

Mr. Olstein regards the difference between a company's reported earnings and its cash flow as being quite an important factor when analyzing companies.  Investors tend to focus (like a type of tunnel vision) on earnings, but because earnings include noncash items, based on management estimates, the bottom line (EPS) may not be giving the true story.

Cash flow, however, is actual money that a corporation generates and that its leaders can use to invest into the business, or give to shareholders.  Some  of the largest gaps between earnings and cash flows are a result of how the corporations account for capital expenditures.

And here I am just going to quote word for word from the meat of Morgenson's story:

"To ensure growth, companies invest in things like new facilities or additional equipment. As time goes on, plants and equipment lose value — the way a car does the moment you drive it away from the dealer — and companies are allowed to write off a portion of these values each year based on management estimates of how long they will generate revenue.
The write-offs are known as depreciation, and the more a company chooses to write off, the greater its earnings are reduced. So managers interested in plumping their profits may depreciate less than they otherwise would or should. Conversely, heavy depreciation amounts can make earnings appear more depressed than the company’s cash flows indicate.
'It’s an investor’s job to determine the economic realism of management’s assumptions,' Mr. Olstein said. 'There is nothing illegal here, but maybe their depreciation assumptions are unrealistic.'
One way to assess the accuracy of management’s estimates is to compare, over time, how much a company spends on new plant and equipment and how much it deducts in depreciation each year. Some of the discrepancies that emerge can be temporary, caused by the lag time between an initial investment and subsequent write-downs for depreciation.
Companies in a growth phase, for instance, will show greater capital expenditures than depreciation as they increase investments in plant and equipment.
But that should be only temporary. If such discrepancies appear on a company’s books year in and out, then investors might well question the depreciation assumptions. Investors confronted by large disparities should discount those companies’ earnings by the amount of excess capital expenditures. Such an exercise reveals how much free cash flow is available to stockholders.
Conversely, if depreciation exceeds capital expenditures, Mr. Olstein says that the earnings at these companies are actually better than they appear — and that this shows up in the cash flows."

 Mr. Olstein goes on to say (I'm paraphrasing) that there are some companies that exist currently in the market that calculate depreciation in such a way as hurt earnings numbers, but have very solid cash flows.

It's also very important to pay attention to the type of business they are in (some businesses require more capital expenditures, others less) and the timing of the capital expenditures in reference to when they take the depreciation (write-downs).  Also make sure you look at several quarterly and annual reports of a company to get a feel for the numbers, not just one report.

None of the words or statements on this blog constitute any form of financial or investment advice.  The author of this blog is not qualified to give financial or investment advice.  If you need financial advice please consult a certified financial planner or other such expert.