Earnings Power Valuation Model

Hewitt Heiserman Jr., EarningsPower.com

I. Common Stocks and Earnings Power:

All investors share a common aspiration: to own a stock that makes a difference. After all, just
think what your life would be like today if you bought $10,000 worth of Paychex, Inc.
(PAYX:Nasdaq) at the beginning of 1990. Imagine you still owned these same shares of the
payroll-services provider at the end of 1999, and they’re worth $350,000. Imagine indeed.

So how do you find your own Paychex?

There are, of course, many ways to prosper handsomely on Wall Street (just as there are many
ways to lose money in the stock market). Some venerable investment strategies are net-net,
sum-of-the-parts, turnaround, spin-off, cyclical, short-selling and merger arbitrage.

Perhaps the most popular investment strategy, though, is to buy shares of a growth, or "earnings
power," company. According to conventional wisdom, an earnings power company is a company
whose earnings steadily rise over many years.

Paychex is an earnings power company. During the 1990s, its per-share earnings increased to 37
cents from 3 cents. Meanwhile, its stock rose to $18.67 from a split-adjusted $0.62.

Of all the companies in the stock market, earnings power companies are the most
glorious. Indeed, firms with long skeins of earnings growth are the corporate equivalents
of Botticelli’s "The Birth of Venus" or Goddard-Townsend Chippendale mahogany block-
and-shell-carved secretaries -- objects of extraordinary achievement that every investor
should study intently. Depending on the number of shares you buy and when, the capital
gains from a stock that performs even fractionally as well as Paychex can help you buy a
home, pay for a child’s college education, care for a loved one, retire a few years early
where it's always sunny or make a generous bequest to a charitable institution.

Extraordinary Achievement: Paychex, Inc.

Year EPS Stock

1990 $0.03 $0.62

1991 $0.03 $0.93

1992 $0.04 $1.48

 1993 $0.06 $2.36

1994 $0.08 $2.70

1995 $0.11 $4.18

1996 $0.15 $9.04

1997 $0.20 $11.13

1998 $0.27 $16.67

1999 $0.37 $18.67

Source: Company reports, BigCharts.com. Stock prices as of

fiscal year ending 5/31

Still, this strategy is not without risk. Here are three reasons:

First, it’s human nature to let your guard down when a firm’s stock price keeps going up and up.

Second, even the bluest of blue-chip stocks can sear a hole in your wallet if you overpay (which,
admittedly, is always more obvious in hindsight).

Third, just because a company keeps making more and more money every year does not mean
that it possesses authentic earnings power. This is because the accrual income statement in
every annual report, 10-K and 10-Q has four substantive limitations: (1) It omits investment in
fixed capital, (2) it omits investment in working capital, (3) it expenses intangible growth-
producing initiatives, and (4) shareholders’ equity is free. As a result, one person’s profit is
another’s loss.

II. Four Substantive Limitations:

Here are brief remarks on the four substantive limitations of the accrual income statement in
every annual report, 10-K and 10-Q:

1. It omits investment in fixed capital. A company makes an investment in fixed capital when
its capital spending is greater than depreciation. The accrual P&L omits investment in
fixed capital because plant, property and equipment are expected to have useful lives
beyond the period in which they are acquired. To fully expense the costs of warehouses,
 lathes or a fleet of trucks would contradict one of the bulwarks of accrual accounting --
that current sales are matched with current expenses and future sales are matched with
future expenses.
2. It omits investment in working capital. Working capital assets are accounts receivable,
inventory and prepaid assets, and working capital liabilities are accounts payable and
accrued expenses. The difference between the two is net working capital -- working
capital for short. When working capital increases from one period to the next, a company
is said to have made an investment in working capital. This use of cash is omitted from
the accrual income statement because it is not an operating expense.
3. Intangible growth-producing initiatives are expensed when incurred. Intangibles covers
things like research and development, marketing and advertising and employee
education. Intangibles are immediately expensed because they are a cost of business.
4. Shareholders’ equity is free. All companies are financed, or "capitalized," with a mix of
debt and equity. Debt capital bears an explicit and legally contracted rate of interest, and
is an expense in the accrual income statement. In contrast, there is no line item for the
cost of equity capital. That’s because companies are not required to pay their owners any
particular rate of return.

As a result of these limitations, a company may appear profitable in the traditional (i.e.,
accrual) sense of the word even though it’s unable to self-fund and/or create value. A
company is able to self-fund when it produces more cash from ongoing operations than it
consumes. It creates value when it produces a return on capital that is greater than its
cost.

What Are ‘Accrual Profits’?

We refer to the income statement found in all public companies’ financial

statements as the accrual income statement. The prefix ‘accrual’ is used for two
reasons: first, when accountants prepare a firm’s financial statement they follow
the rules of accrual accounting; and second, the term distinguishes it from the
defensive and enterprising income statements (see Section III, Opposing
Personality Types). Accrual profits, then, are the same thing as net income as
determined by generally accepted accounting principles.

III. Opposing Personalities:

In The Intelligent Investor, (1973) Benjamin Graham describes two types of investors: defensive
and enterprising. The chief aim of the defensive investor, Graham explains, is to avoid committing
"serious mistakes or losses." In contrast, the primary goal of the enterprising investor is to own
companies "more attractive than average." To put it in vocational terms, the defensive investor
emphasizes "safety first" like a commercial banker, while the enterprising investor thinks in terms
of growth for tomorrow, like a venture capitalist.

Ideally, the accrual income statement would accommodate both defensive and enterprising
investor. Unfortunately, however, the income statement in every annual report, 10-K and 10-Q is
often poorly suited to meeting the needs of either personality type. This can cost you money or
waste your time.

From the defensive investor’s perspective, the problems with the accrual income statement are its
omissions of investment in fixed and working capital. This is because they are uses of cash.
Every dollar invested in fixed and working capital is a dollar less that can pay interest, reduce
debt, repurchase stock or boost the dividend. As a result, a firm may appear profitable even
though it’s unable to self-fund. Companies that can’t self-fund eventually go bankrupt.
To identify companies that can self-fund, the defensive investor turns to the "defensive" income
statement. The defensive P&L expenses investment in fixed and working capital immediately. If a
company makes money after these two adjustments, then it is has made a defensive profit.
Companies with defensive profits are able to self-fund and finance their growth with internally
generated free cash flow, while companies with defensive losses are at risk of running out of
money. (Intangibles are immediately expensed because they are uses of cash. As for
shareholders’ equity, it is free because it is a noncash cost.)

Meanwhile, from the enterprising investor’s perspective, the problems with the accrual income
statement are that intangible growth-producing initiatives are expensed in the year incurred, and
that shareholders’ equity is "free." Expensing intangibles penalizes forward-thinking companies
that are laying the foundation for higher future sales and earnings. As for shareholders’ equity,
because no charge is recorded for its use a company may appear more profitable than perhaps it
really is.

To remedy these deficiencies, the enterprising investor turns to the "enterprising" income
statement. The enterprising P&L converts intangibles from operating expenses to capital assets,
thus enabling apples-to-apples comparisons of hard-asset companies with soft-asset firms in, for
example, drugs, software and technology. As for shareholders’ equity, it is expensed, typically at a
minimum rate of 10%. If a company makes money after these adjustments, then it has made an
enterprising profit. Companies with enterprising profits create value and make good use of their
owners’ time, while companies with enterprising losses destroy value and squander wealth.
(Investments in fixed and working capital are not expensed, at least directly, because they are
expected to produce higher future sales and earnings. That’s why they’re called investments.)

Comparison of the Defensive and Enterprising Investor

Personality Commercial banker Venture capitalist

Objective Make sure company Check whether

can self-fund, company is creating
because companies value, because
that can’t may go companies that can’t
bankrupt and cost you waste owners’ time
money and may cost you time

Income statement Defensive Enterprising

Four (4) #1. Expenses when Not applicable

limitationsof Investment in incurred
the accrual fixed capital
income #2. Expenses when Not applicable
statement Investment in incurred
working
capital

#3. Expenses when Capitalizes on the

Intangibles incurred balance sheet as an
are expensed asset and then
when incurred depreciates over an
appropriate period

#4. Not applicable Expenses at the firm’s

Shareholders’ estimated cost of
equity is free capital

Key assumptions What part of capital Cost of equity;

spending is growth depreciation period for
capex ? intangibles

IV. The Earnings Power Box :

A proposition: A company has authentic earnings power when it is profitable the way both
defensive and enterprising investor thinks about profits. Thus,

Asking whether one alternate income statement is "better" than the other is like asking whether
your car’s gas pedal is more important than the brake. They are both important, but for different
reasons. The defensive income statement tells you whether a company can self-fund; the
enterprising income statement reveals whether the business is creating value.

This is key: A company may be able to self-fund but not create value, or create value but not self-
fund. The two are not the same, and both are essential to having authentic earnings power.

To illustrate, let’s examine Paychex, Lucent (LU:NYSE), Enron (ENRNQ:OTC BB) and
Bethlehem Steel (BHMPQ:OTC BB). Each company had accrual profits for the specified period
(see below, Quality of Profits chart). Crucially, however, only Paychex had authentic earnings
power; i.e., it was profitable the way defensive and enterprising investors think about profits.
Meanwhile, Lucent had a defensive loss, Enron had a defensive and enterprising loss, and
Bethlehem Steel had an enterprising loss. Thus, the quality of accrual profits for these three
companies were suspect.
We recognize the need for using the defensive and enterprising income statements to gauge the
quality of a firm’s accrual profits. Using an x-y scatter chart, we can recast these two alternate
P&L's in picture form, so you can effectively visualize the information. The scatter chart shows us
what the accrual ledger often obscures: whether a company meets our two condition precedents
of authentic earnings power, namely, the ability to (1) self-fund, which is assessed by the
defensive income statement, and (2) create value, which is assessed by the enterprising income
statement. Enterprising profit (loss) is plotted on the x (horizontal) axis, defensive profit (loss)
goes on the y (vertical axis).

As you would expect, the best companies to own are those situated in the upper-right, or
"earnings power," box. This is the long-term cautiously greedy investors' Valhalla -- their
investment center of gravity. Companies in the Earnings Power Box (EPB) offer the prospect of
ample capital gains while also letting you sleep peacefully at night.

The worst companies are situated in the lower-left box, even if they are profitable in the accrual
sense of the word. If you own a LLB company, then kiss it goodbye fast. (The exception to this
rule is that the firm’s valuation is compelling and you believe it is in the midst of a successful
turnaround.)

Businesses in the upper-left box are self-funding but not creating value, while firms in the lower-
right box are creating value but not self-funding.
As we see, although each of our four companies was profitable on an accrual basis, Paychex was
the only company situated in the EPB.

At the other end of the spectrum is Enron. Although the energy trader made money in the
traditional sense of the word, it was lost money the way defensive and enterprising
investors think about profits. Contrast what this model reveals about Enron’s 2000
performance with these breezy sentences from its annual report:

Enron’s performance in 2000 was a success by any measure . . . The

company’s net income reached a record in 2000. Enron is laser-
focused on earnings per share, and we expect to continue strong
earnings performance.

To be sure, not every company in the EPB will become a gold mine like Paychex, nor will every
business in the LRB, LLB and ULB become sinkholes like Lucent, Enron and Bethlehem Steel.
Still, unless you're as rich as Croesus, doesn’t it make sense to put your hard-earned funds on
the highest-probability bets, especially if you intend to own the company for the long haul?

If a company you own is not in the EPB, find out why. That’s because the other three boxes are
"pain" boxes. The model is telling you that something is wrong with the business, or at least it’s
not as profitable as it should be. Maybe the company is slow to collect its receivables. Maybe its
warehouses are stuffed to the roofs with inventory that won’t sell. Maybe the company is in the
midst of an aggressive capital spending program (which may or may not succeed!). Or maybe it’s
just not profitable enough in relation to all the capital that’s been invested in the business.

V. Methodology:
Companies do not tell you whether they are situated in the Earnings Power Box . Therefore, we
must build a defensive and enterprising income statement ourselves. Proceed as follows:

1. Obtain a firm’s annual report or 10-K for the last several years.
2. Use key data from the income statement, balance sheet, statement of cash flows and
footnotes to build our two alternate P&L’s.
3. Plot enterprising profit (loss) on the (x) horizontal axis, and defensive profit (loss) on the y
(vertical) axis. The intersection of these two points will be in one of four boxes. The best
companies (but not always the best stocks) are situated in the upper-right, or "earnings
power," box.

To illustrate, let’s return to Paychex. As calculated below, Paychex’s accrual, defensive and
enterprising profits for the year ended May 31, 1999 were $0.37, $0.35 and $0.32, respectively.
Each of the accrual income statement’s four substantive limitations is highlighted in bold letters.

3 Types of Profits: Paychex, Inc. For the fiscal year ending May 31, 1999.
(Thousands except per-share)

Income Statement Accrual Defensive Enterprising

Revenue $1,175,428 $1,175,428 $1,175,428

Cost of goods sold 730,088 730,088 730,088

SG&A 257,778 257,778 257,778

Other expenses (income) (a) (12,581) (10,814) (200)

Investment fixed capital n/a 7 n/a

Investment working capital n/a 6,417 n/a

Intangibles 0 0 0

Total operating expenses 975,285 983,476 987,666

Earnings before interest and taxes 200,143 181,138 187,762

Interest expense (b) 0 0 11,091

Pre-tax profits 200,143 191,952 176,671

Taxes 61,044 61,783 59,089

Other expenses (income) 0 0 0

Profit $139,099 $130,169 $117,582

Per-share (373,182 diluted shares) $0.37 $0.35 $0.32

Source: Company reports, EarningsPower.com

(a) Accrual includes $12,581 of investment income. Defensive includes $10,814 for amortization other intangibles. Enterprising
includes a $200 increase in current deferred credits.

(b) Enterprising interest equals the firm’s estimated weighted average cost of capital times average capital for two years. Capital is
the sum of the book (i.e., accrual) value of interest-bearing debt, preferred stock and shareholders’ equity, as well as deferred
taxes, capitalized operating leases, reserves, net capitalized intangibles, cumulative goodwill amortization, unrecorded goodwill,
cumulative unusual (gains) losses A/T, cumulative extraordinary (gains) losses A/T and (non-operating cash and marketable
securities).

By combining results from Paychex’s 1999 performance with earlier years we can examine
earnings quality for the entire decade. It’s a remarkable chart, as evidenced by the close
proximity of defensive and enterprising profits to accrual profits. This is the chart of a company
with high-quality, or profitable, growth.

The hallmark of extraordinary corporate achievement is the Earnings Power Staircase, so-named
because when defensive and enterprising profits steadily rise over time the x-y scatter chart looks
like the profile of a staircase. (In this analogy the rise is the incremental increase in defensive
profits, while the run is the periodic change in enterprising profits.)
As depicted below, Paychex had a Staircase during the 1990s, which helps explain why the stock
appreciated 2,911%. Not only was the firm situated in the EPB during most of the decade, but it
kept moving in an upper-right direction.

VII. Profitable Growth:

The Earnings Power Box will point you towards companies that can self-fund
and create value and away from those at risk of costing you money or wasting
your time. Of course other investors will use the defensive and enterprising
income statements to find the best merchandise for sale on Wall Street and to
avoid the investment dreck. Thus a paradox: The higher the quality of a firm’s
accrual profits the more speculative the stock is likely to be.

One way to gauge whether a firm’s valuation is cheap, dear or middling is

to look at its price-earnings ratio. The P/E ratio is calculated by dividing
stock price by earnings per share. A high P/E ratio normally means that
Wall Street is enthusiastic about a firm’s future growth prospects (which
may or may not be realized); a low P/E ratio suggests that investors are
nervous about what lies around the corner.

Earnings Bought Cheap

Several years ago investment adviser Tweedy, Browne compiled 44 studies of

investment approaches and characteristics associated with exceptional returns.
Included in What Has Worked In Investing are nine studies that fall under the
category "earnings bought cheap." In every instance, the lowest P/E stocks
produced the highest subsequent returns, and the highest P/E stocks produced
the lowest subsequent returns. The lesson here is clear: Exercise extreme
caution when buying richly valued stocks.

P/E ratios are readily available on many financial Web sites as well as in the
business section of most newspapers. Despite their widespread use, however,
P/E ratios suffer from two problems – their P and their E.

The problem with the numerator P for price is that it does not explicitly take into
account excess cash, marketable securities or debt that a firm may employ. As a
result, a company may be more or less expensive than its stock price indicates.
As for the denominator E for earnings, they are a function of the accrual income
statement. (See section II. Four Substantive Limitations, to learn what’s wrong
with net income and earnings per share.)

Instead, consider using the Profitable Growth Value model, which is not affected
by the limitations of the P/E ratio. According to the PGV, a firm’s stock price is
equal to the sum of three building blocks, or "tranches," of value. These tranches
are realizable net assets, annuity value and profitable growth. Thus,

Realizable net assets is corporate net worth reduced, when appropriate, by an

"advance rate." The advance rate is your estimate of what a particular asset is
worth if sold in an arms-length transaction. High-quality assets merit high advance
rates; low-quality assets get low advance rates. Annuity value is a firm’s most
recent profits (defensive or enterprising, your pick) divided by the weighted
average cost of capital. Think of annuity value as the value of a firm’s ongoing
operations if profits remain fixed at their current level in perpetuity. The higher a
firm’s WACC the lower its annuity value, and vice versa. By definition, profitable
growth, our third and final tranche, is future profits (again, defensive or
enterprising) that exceed their current, normalized, level. Profitable growth is not
calculated directly, instead, we rearrange our equation, as shown below.

To illustrate, let’s examine Paychex. There are four steps to calculating PGV.

Step #1 is obtaining a firm’s stock price. In Paychex’s case, its stock price on May
31, 1999 was $18.67.

Step #2 is estimating realizable net assets. As shown below, a best guess is

$49.4 million, or $0.13 a share.
Realizable Net Assets: Paychex, Inc. Fiscal year ended May 31, 1999. (All
amounts in thousands)

Asset Balance Advance Realizable

Type Sheet Rate Amount

Cash $52,692 100% $52,692

Marketable securities 290,555 100% 290,555

Receivables 62,941 90% 56,647

Current deferred taxes 1,364 80% 1,091

Other current assets 24,045 75% 18,034

Non-operating current assets 1,361,523 75% 1,021,142

Net fixed capital 65,931 60% 39,559

Deferred taxes 1,417 50% 709

Other assets 12,633 50% 6,317

Total $1,486,745

Less: Liabilities 1,437,301

Realizable net assets $49,444

Shares outstanding 373,182

 Per-share RNA $0.13

Step #3 is calculating annuity value. This number equals current profits divided by
the weighted average cost of capital. In Paychex’s case, defensive and
enterprising profits were $0.35 and $0.32 a share, respectively. At a 10.0%
WACC, the firm’s annuity value for the defensive and enterprising investor rounds
out to $3.49 and $3.15, respectively.

Step #4 is determining profitable growth. As shown below (see box), 81%

and 82% of the payroll-services provider’s stock price is due to
expectations for higher future defensive and enterprising profits, i.e.,
profitable growth.

Profitable Growth: A snapshot of investor expectations about future growth in

defensive and enterprising profits at Paychex, Inc. on May 31, 1999

Income statement Defensive Enterprising

Tranche Amount % total Amount % total

Stock price $18.67 100% $18.67 100%

- Realizable net assets 0.13 1% 0.13 1%

- Annuity value 3.49 18% 3.15 17%

= Profitable growth $ 15.05 81% $15.39 82%

What’s the maximum amount to pay for profitable growth?

Ideally, you want to get higher future defensive and enterprising profits for free. Of
course, few companies able to self-fund and create value are that cheap. Still, to
have a margin of safety in case of what Benjamin Graham called "miscalculation
or bad luck," it is vital to distinguish between what you dependably know about a
firm’s balance sheet and current business operations and your uncertain hopes for
the future. Thus, of PGV’s three tranches of value, profitable growth is the diciest.
In Paychex’s case, time will tell whether these lofty expectations are warranted.

Copyright 2002. Hewitt Heiserman Jr., EarningsPower.com.