Ratios as Forecasters of Returns, Shiller, 1996
The simplest and most widely used ratio used to predict the market
is the price-earnings ratio. The use of one-year's earnings in
the price-earnings ratio is an unfortunate convention, recommended
by tradition and convenience rather than any logic. As long ago
as 1934, Benjamin Graham and David Dodd, in their now famous textbook
Security Analysis, said that for purposes of examining such ratios,
one should use an average of earnings of "not less than five
years, preferably seven or ten years."
on Valuation, Mauboussin, Legg Mason, 2005
Price-earnings (P/E) multiples are by far the most popular valuation
metric on Wall Street. Still, most investors don't have a clear
sense of what a price-earnings multiple implies about a company's
future financial performance, or how a company's price-earnings
multiple will likely change over time. In this short piece, we offer
an analytical bridge between earnings multiples (and multiples of
any kind) and sound economic reasoning (The role of growth in valuation
is completely contingent on a firmís return on capital). (see also
Buffett on Growth Vs. ROIC, 1992,
Errors in DCF Models, Michael Mauboussin, Legg Mason, 2006
First principles tell us the right way to value a business is to
estimate the present value of the future cash flows. While most
Wall Street professionals learned about discounted cash flow (DCF)
models in school, in practice the models they build and rely on
are deeply flawed. Not surprisingly, the confidence level in these
DCF models is very low. This faint confidence is not an indictment
of analytical approach but rather of analytical methods. Here's
our list of the most frequent errors we see in DCF models. We recommend
you check your models, or the models you see, versus this list.
If one or more of the errors appear, the model will do little to
inform your business judgment.
Valuation of Bank Holding Companies, Calomiris and Nissim, 2007
Despite their importance in the stock market, there is no existing
satisfactory valuation approach for banks comparable to the discounted
cash flow approach used for nonfinancial firms. This study develops
and tests a valuation model for Bank Holding Companies, which is
based on the cross-sectional relationship between the market-to-book
ratio and proxies for the value generated by various bank activities
and bank attributes.
for Intangible Assets: There Is Also an Income Statement, Stephen
When Benjamin Graham was first developing the principles of fundamental
analysis some 80 years ago, the bulk of a firmís value came from
its tangible assets, the physical materials the firm was composed
of: its factory, its inventory on hand, its fleet of delivery trucks.
In the ensuing shift away from manufacturing, a firmís assets are
increasingly in its entrepreneurial ideas, brands and research and
development. Distribution systems have replaced delivery trucks
as the main source of value. Professor Penman provides evidence
that income statements are the best source for deciphering the value
that intangible assets bring to the bottom line.
Taxes, and Reversion to the Mean; ROIC Patterns: Luck, Persistence,
and What to Do About It; Michael Mauboussin, Legg Mason, 2007
Analysts modeling future corporate financial performance should use
past ROIC patterns, including a strong tendency toward mean reversion,
as an appropriate reference class but rarely do. Some companies do
post persistently high or low returns beyond what chance dictates.
But the ROIC data incorporate much more randomness than most analysts
Patterns and Shareholder Returns, Michael Mauboussin, Legg Mason,
Does an understanding of ROIC patterns help with stock picking?
This piece addresses that question and finds that there is a huge
payoff for correctly anticipating changes
in ROIC. Unfortunately, there appears to be no simple,
systematic way to predict future, unanticipated ROICs.
on Invested Capital (ROIC) and Enterprise Value/Invested Capital
Notwithstanding the fascination of Wall Street with EPS growth rates,
there is neither a statistical relationship nor a common sensible
relationship between EPS growth rates and stock prices. Over an
intermediate- to long-term investment horizon, an investor's primary
focus should be value creation - how much economic value has been
and will be created from the funds invested in and deployed by a
company - and Return On Invested Capital (ROIC) is a superior quantitative
touchstone with which to assess value creation.
Sales and ROIC, Edward Lampert, Chairman of Sears, 2005
The discussion of profitable growth brings me to the issue of same-store
sales, and why I believe it is not always the best measure of a
retailer's performance. Many analysts and commentators focus on
same-store sales (SSS) as the most important statistic in retail,
almost to the exclusion of any other statistic (even above profit).
I consider SSS to be an important metric for retail performance,
but one that is vastly overrated.
Level and Persistence of Growth Rates, Chan, Karceski, Lakonishok,
Expected long-term earnings growth rates are crucial inputs to valuation
models and for cost of capital estimates. The paper analyzes historical
long-term growth rates across a broad cross-section of stocks using
several operating performance indicators. We test whether growth
persists, and whether it is forecastable. Cases of very high growth
have occurred, but are relatively rare. There is scant persistence
in growth beyond chance, and limited ability to identify firms with
high future long-term growth. IBES forecasts are too optimistic,
and have low predictive power for long-term growth. Regressions
using a variety of predictors confirm the low predictability in
growth. Valuations that assume persistently high growth over prolonged
periods rest on shaky foundations.
Some Companies Abuse Cash Flow
Cash flow is often considered to be one of the cleaner figures in
the financial statements. Companies have a way to inflate or artificially
"pump up" their earnings - it's called cash flow manipulation.
Here we look at how it's done, so you are better prepared to identify
Sustainable Cash Flow: A Study of the S&P 100 Using 2002 Data
Operating cash flow in 2000, 2001, and 2002 for the S&P 100
was adjusted to remove items that may provide misleading signals
of operating performance. Nine adjustments were made, separated
into three categories - (1) where flexibility in GAAP for cash flow
reporting was used to alter cash flow, (2) where the requirements
of GAAP result in misleading operating cash flow amounts, and (3)
where nonrecurring operating cash receipts and payments lead to
operating cash flow that is non-sustainable. Adjustments resulted
in an average reduction in operating cash flow in 2000 of 5% and
an average increase in operating cash flow in 2001 of 3.1% and in
2002 of 2.9%. Certain individual company adjustments were quite
significant, resulting in some cases, in much more operating cash
flow than actually reported, and in other cases, much less.
Impact of Securitizations of Customer-Related Receivables on Cash
Flow and Leverage: Implications for Financial Analysis
Understanding the extent to which transactions create recurring
cash flow is vital to investment and credit analysis. In addition
to cash flow, the extent to which a firm uses borrowed funds or
financial leverage to finance its operations impacts its overall
financial health. In this research report we look at the financial
statement effects of customer receivable securitization transactions
and their effects on analysis from two points of view - their impact
on cash flow and financial leverage. The report includes a discussion
of why companies choose to use the securitization tool, how they
use it, and what goals they achieve. Our findings indicate that
securitizations can have significant effects on a firm's apparent
ability to generate sustainable cash flow and on its use of debt
financing. (see also Fitch's
analysis of accounting issues in Y2006, p.13)
Re-examination of Cash Flow Reporting in the Presence of Overdrafts
Numerous companies maintain cash overdraft balances. These seemingly
innocuous accounts can have material effects on reported amounts
of cash and operating cash flow. In this report, we survey reporting
practices for overdrafts and draw attention to cases where analysts
may be misled.
Inclusion of Short-term Investments in Operating Cash Flow
Companies use short-term investments as a vehicle to park surplus
cash. When such investments are classified as trading securities,
cash used in their purchase and proceeds provided from their sale
are included in operating cash flow. Classifying cash flow from
trading securities as operating by non-financial companies can mislead
users of financial statements regarding a company's ability to generate
cash flow from sustainable sources. In this report we survey the
practices of non-financial companies regarding their inclusion of
cash provided (used) by trading securities in operating cash flow.
Reporting Practices for Customer-Related Notes Receivable
While there is general agreement on the reporting treatment for
changes in accounts receivable in the computation of operating cash
flow, reporting practices differ when customers are offered more
formal repayment arrangements, for example, in the form of notes
receivable. Some companies include such customer-related receivables
in the computation of operating cash flow, while others report them
in the investing section. Reporting such receivables as investing
cash flow results in higher operating cash flow when the balance
of such receivables is rising. As a result, the potential exists
for a misimpression of a company's operating performance. In this
study we highlight cash-flow reporting practices for such customer-related
Investing and Financing Activities and Free Cash Flow
Items of property, plant and equipment are often acquired through
non-cash investing and financing activities. In these transactions,
equipment-purchase financing is provided at the time of purchase.
While such transactions increase a company's productive capacity,
they are not reported as capital expenditures in the statement of
cash flows. Accordingly, free cash flow calculated based on capital
expenditures reported in the statement of cash flows will often
be overstated when assets are acquired through such non-cash transactions.
In this report we look at a series of non-cash investing and financing
transactions and assess their effects on calculated free cash flow.
Earnings Management, Itay Kama, Nahum Melumad, 2010
In recent years, there has been increased scrutiny of financial reporting
and greater analysts and investors attention to indicators of potential
earnings management, in particular, to cash and accruals relative
to earnings and revenues. We assert that, in response, firms have
increased their focus on cash management aimed at aligning these variables,
which has resulted in camouflaged earnings management (An
example of an AC cash management transaction is the factoring of receivables
(also securitization and discounting)). Analytically, we
develop indicators of camouflaged earnings management and use them
empirically to test whether the alignment of cash and earnings has
intensified following the legislation of the Sarbanes-Oxley Act. The
empirical results are all in line with, and reinforce, our assertion..
Detection of Earnings Manipulation, Beneish, 1999
This paper presents a model to distinguish manipulated from
non-manipulated reporting. I define earnings manipulation
as an instance where management violates Generally Accepted Accounting
Principles (GAAP) in order to beneficially represent the firmís
financial performance. I use financial statement data to construct
variables that seek to capture the effects of manipulation and preconditions
that may prompt firms to engage in such activity. Since manipulation
typically consists of an artificial inflation of revenues or deflation
of expenses, I find that variables that take into account the simultaneous
bloating in asset accounts have predictive content. I also find
that sales growth has discriminatory power since the primary characteristic
of sample manipulators is that they have high growth prior to periods
during which manipulation is in force. I find that sample manipulators
typically overstate earnings by recording fictitious, unearned,
or uncertain revenue, recording fictitious inventory, or improperly
capitalizing costs. The evidence indicates that the probability
of manipulation increases with: (i) unusual increases in
receivables, (ii) deteriorating gross margins, (iii) decreasing
asset quality (as defined later), (iv) sales growth, and (v) increasing
Toolbox: Beneish MScore
broke the story?, Pizzani, 2004
A look at 10 of the worst U.S. accounting scandals, and who brought
them to light. This is a two-part series (part
two) that examines some of the baddest "bad boys"
of the world of corporate accounting scandals - who actually broke
the story, what the company executives did and what transgressions
caused their house of cards to tumble.
Destruction and Financial Reporting Decisions, Graham, Harvey
and Rajgopal, 2006
We document a willingness to routinely sacrifice shareholder value
to meet earnings expectations or to smooth reported earnings.
While much previous research has focused on the use of accounting
for earnings management, such as accrual decisions, we provide
new evidence of the widespread use of 'real' earnings management,
which might include deferring a valuable project
or slashing research and development expenditures.
Use of Special Items to Inflate Core Earnings, McVay, 2004
Prior accounting research has documented two main methods of earnings
management. The most commonly-studied method of earnings management
is accrual management. Essentially, a manager can borrow earnings
from future periods, through the acceleration of revenues or deceleration
of expenses, in order to improve current earnings. Managers can
also use accrual management to overstate current period expenses
(i.e. take a 'big bath'). The overstatement can be used to offset
future operating expenses or reversed into income in future periods.
A second type of earnings management can occur through the manipulation
of real activities, such as providing price discounts to increase
sales, cutting discretionary expenditures such as R&D and
structuring other transactions, such as debt-to-equity swaps or
asset sales to manage earnings. This paper investigates a third
method of earnings management, the classification of core
operating expenses as special within the income statement.
The misclassification of expenses within the income statement,
from core to transitory, offers a unique earnings management tool.
This misclassification can influence investors' perceptions of
firm performance and firm value. In this paper I document the
shifting of operating expenses, such as cost of goods sold, to
special items in the year the special item is reported.
R&D: To Capitalize or Expense?, Deng and Lev, 2004
The FASB recently proposed the capitalization of acquired in-process
R&D costs to replace the current practice of expensing this
item. This proposal will likely be strongly opposed by corporate
executives. The consequences of the immediate expensing of IPRD
and the means for managing (manipulating) earnings they create attracted
the media attention. As indicated by the above example of Lotus'
acquisition, the higher the valuation of IPRD - a very soft and
subjective value - the lower is the residual value of goodwill,
and in turn the lower the hits to future earnings from goodwill
amortization. The immediate expensing of IPRD also obviated the
future amortization of this asset had it been capitalized, further
contributing to future reported earnings. Finally, the immediate
expensing of IPRD substantially reduced the asset and equity bases
of the acquiring company, thereby inflating widely used profitability
measures, such as the return on assets or equity.
"Debate over whether stock options should be expensed has finally
come to an end, but valuation issues remain, and identifying related
cash outflow is a challenge. Fitch believes that the real
cost of employee options is not the amount that will be
reported in the income statement; rather, it is the propensity of
companies to offset exercised employee options with share
repurchase programs and the associated cash outlay".
Options: Old Game, New Tricks, BusinessWeekOnline, 2005
After losing a decade-long battle with regulators, U.S. companies
will finally be required to deduct the cost of options from their
earnings starting in fiscal 2006, which for most means the quarter
beginning in January. Companies are finding ways to lower options
costs despite stricter rules. One gambit is tinkering with the formulas
used to assign options a value, which can result in lower costs.
A more popular strategy has been to accelerate the vesting of options.
Decades of Overstated Corporate Earnings, The Surprisingly Large
Exaggeration of Aggregate Profits, The Levy Forecasting Center,
Over the past 10 years, the financial media have spotlighted case
after case of earnings misrepresentation and reported the SEC's
and other authorities' efforts to reign in misleading practices.
Yet the focus of public concern remained on finding the bad apples;
little attention was paid to the quality of the entire bushel. People
are starting to ask, "Just how widespread and serious is the
overstatement of aggregate corporate profits?" The answer is
startling. The macroeconomic evidence indicates that corporate operating
earnings for the Standard & Poors' 500 have been significantly
exaggerated for nearly two decades - by about 10 percent or more
early in this period and by over 20 percent in recent years. These
figures are conservative - the magnitude of the overstatement may
be considerably larger.