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, Heiserman explains, 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. It looks like a regular statement, but it corrects for the first two limitations Heiserman pointed out. First, it expenses all capital investments in the year they're incurred. Second, it treats a company's investments in working capital as if they were expenses. This statement is stringent 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 of Heiserman's limitations. First, it treats R&D and advertising costs as capital assets, depreciating them over their useful lives. Second, it treats equity capital held on the balance sheet as an expense.
Here are the statements for BP 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.
|BP||($1.37), ($1.75)||($0.07), ($0.15)||$0.32, ($0.75)||$0.20, $0.07|
||$0.19, ($2.42)||$0.20, ($2.26)||$4.48, $1.57||$3.95, $1.90|
||($0.49), ($2.62)||$1.24, ($3.09)||$1.61, ($3.27)||$2.12, ($2.23)|
||$0.21, ($2.57)||($0.29), ($1.26)||$1.44, ($3.53)||$3.20, $0.59|
Source: Capital IQ, a division of Standard & Poor's.
BP's enterprising and defensive earnings have fluctuated a great deal since 2007 but moved decidedly down in 2010. Exxon seems to have moved clearly down, while the other companies have seen fluctuations over the same time period.
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 BP.
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, BP's enterprising and defensive earnings have fluctuated and hit a low in both categories in 2010. The direction of the movement over the past few years is down and to the left, into the worst quadrant.
Foolish bottom line
The enterprising and defensive statements can provide you some key insights into a company's earnings power and quality. Just because a company doesn't make it into the upper right quadrant, that 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;