Microsoft Has High-Quality Earnings

Microsoft (Nasdaq: MSFT) reported $23 billion in net income over the last four quarters. But how good are those earnings, really? Apparent profits on the income statement won't always tell you the whole story. Instead of just looking at the reported numbers, you need to find companies with authentic earnings power. So how do the earnings at Microsoft look?

It's earnings that count
In his book, It's Earnings That Count, Hewitt Heiserman explains how to determine the quality of a company's profits. First, he points out four key limitations of the traditional income statement:

• Fixed capital investments are not fully expensed, but rather depreciated over time.
• Investments in working capital are left off the income statement.
• Intangible growth-generating expenditures (such as advertising) are immediately expensed, even though they pay off over time.
• Retained earnings that are reinvested back in the business are not treated as an expense.

To compensate for these defects, Heiserman suggests that investors recalculate the income statement, creating both a defensive income statement and an enterprising statement. If a company can achieve profits on both statements, then that business has authentic earnings power.  And that, explains Heiserman, can lead to safer and more profitable investments.

The defensive income statement
The defensive statement shows whether a company can self-fund and generate more cash from its operations than it uses. The defensive statement looks like a regular statement, but corrects for the first two limitations above. First, it expenses all capital investments in the year they're incurred. Second, the defensive statement treats a company's investments in working capital as if they were expenses. This statement is stringent in order to provide the most conservative look into the company's operations.

The enterprising income statement
The enterprising statement reveals whether the business can create value and turn shareholder money into even greater profit over time. It corrects for the second two limitations mentioned above. First, it treats R&D and advertising costs as capital assets, depreciating them over their useful lives. Second, the enterprising statement treats equity capital held on the balance sheet as an expense.  

Here are the statements for Microsoft and a few peers over the last few years, divided into enterprising and defensive profits, respectively. We’re looking for solidly profitable numbers that grow over time, in order to show authentic earnings power.

Source: Capital IQ, a division of Standard & Poor's. (Enterprising, Defensive earnings)

Microsoft’s enterprising earnings fell slightly in 2008, but began to gradually increase again so that they are higher than they were in 2007.  Its defensive earnings have fluctuated over time, but they are higher in 2010 than they were in 2007.  While Microsoft shows the general upward trend that we like to see, these peers consistently grew both defensive and enterprising profits faster.

The earnings power chart
For an illustrative depiction of a company's earnings power, Heiserman recommends graphing the earnings from the defensive and enterprising statements, plotting enterprising profits along the horizontal axis and defensive along the vertical. I've done this for Microsoft below.

Ideally, you want to see the company generating both earnings figures in the upper right quadrant. A staircase of escalating earnings toward the upper right over time would be even better. That pattern would show that the company is consistently generating value and self-funding, two great signs of a winning company. As the chart demonstrates, Microsoft’s enterprising and defensive profits both show a general upward trend ever deeper into the best quadrant, exactly the kind of move you should be looking for.   

Foolish bottom line
The enterprising and defensive statements can provide you with some key insights into a company's earnings power and quality. Just because a company doesn't make it into the upper right quadrant doesn't mean it can't be a good investment. But if it isn't at least moving toward the upper right, you'll want to dig in deeper to find out why. To keep an eye on these companies, add them to your Watchlist:

• Add Microsoft to My Watchlist.
• Add Oracle to My Watchlist.
• Add Google to My Watchlist.
• Add Apple to My Watchlist.