Net income seems like a very straightforward concept. Ideally, we should be able to rely on the accounting net income figure as the best measure of the financial performance of a company.
It is very important to understand:
- Which portion of reported earning represents one-time items?
- Which portion of a companies reported earnings are likely to be on-going
- How expense estimates have affected the earnings
- How accounting rules have affected the earnings
- That net income applicable to common shares is lower than net income if preferred dividends are paid
- What are the “real” normalized earnings?
The following are examples of things that cause the net income to not be “real” because it is based on estimates and accounting rules:
- In capital-intensive industries, the accounting depreciation expense can over or under estimate the true decline (or rise) in the value of fixed assets by a very wide margin. If the depreciation expense is too low the company will likely eventually realise a loss when it eventually disposes of or retires a major fixed asset. Conversely some assets may be appreciating in value and the associated depreciation expense is not a “real” expense.
- Mining and exploration companies are allowed to capitalize exploration costs rather than expensing them in the period incurred. When they do this, the net income can be grossly over-stated if it eventually turns out that the mine or well is not an economic find. In particular, the “true” net income of small exploration companies may be much less than reported.
- Some companies capitalize various development and customer acquisition costs that are expected to provide future benefits. Such intangible assets sometimes end up not providing the hoped for future benefits. In those cases the net income will have been over-stated.
- Manufacturing companies capitalize the expenses incurred in creating inventory. In some cases the inventory may end up being sold for much less than the anticipated price. In those cases the net income would be over-stated in the period the inventory was created.
- Most research and development costs are required to be expensed as incurred. But these “expenses” are actually designed to be investments that will yield benefits in future years. This required practice is conservative and tends to cause net-income to be understated. This factor seems to be causing an under-statement in earnings of many computer software related companies, including Nortel.
- When a corporation purchases another company it often pays a premium over book value, which creates an intangible asset called “goodwill”. The purchaser is then required to amortise this intangible asset. It can be argued that this expense causes net income to be under-stated if the true value of the intangible “goodwill” is not actually declining.
- Income tax can be artificially low due to one-time tax deductions that are not sustainable in future years. We calculate the apparent tax rate to check for this. A calculated income tax rate lower than about 35% is probably unsustainable.
The following are examples of one-time impacts on reported earnings:
- Whenever a company disposes of a major asset there will be a gain or loss on disposal as the cash proceeds will inevitably differ from the book value of the asset. These one-time gains and losses can easily be larger than the net income in a normal year. The same affect occurs when company “writes-down” the value of a major asset to recognise that the asset is now worth less than its carrying value.
- Companies sometimes take one-time restructuring charges in association with severance payments to employees in a “down-sizing” or cost reduction operation.
- Net income will not be representative if the company suffered a major production problem or strike during the year.
In our analysis of companies we attempt to deal with the problem of unrepresentative net income by basing our calculations on up to 5 different views of net income. We look at net income for the last two fiscal years, for the latest four quarters, for the latest fiscal year adjusted for unusual items and/or adjusted to reverse the expensing of goodwill amortization and of R&D “expenses” and sometimes the forecast net income for the next fiscal year. By calculating the P/E based on all of these views of net income we get a sense of what the “representative” P/E is. This helps us to determine a representative P/E ratio and net income level and will prevent us from being fooled by an artificially low P/E ratio and high net income.
In calculating the intrinsic value of shares based on forecast future earnings we use the latest 4 quarters of earnings adjusted for unusual items and/or accounting items as the starting point.
The issue of expense estimates affecting earnings is more difficult to adjust for. In our analysis we deal with this issue by examining the accounting methods. We note any concerns under “accounting issues”.
Calculating a representative or normalized level of current net income is easiest when the net income is level or is trending up at a steady level.The most difficult case is when net income is volatile and when there appear to be several unusual items affecting net income.
A few companies provide investors with supplemental information that indicates a normal level of net income, adjusted for unusual gains and losses. This is very useful and we wish all companies would do so.
It should go without saying that increases in net income are meaningless if the number of shares has also increased proportionately. Investors should always focus on net income per share (and after dilution for stock options) in evaluating growth in net income.
If preferred dividends are present, then investors should focus on net income applicable to common shares and not “net income” as such. Some companies discuss their performance in terms of net income, when they should be discussing the net income applicable to common shares. We consider that to be bad practice.
In conclusion, our advice is this: Never assume that the actual net income or the resulting P/E ratio is representative. Always work with net income and P/E figures that are adjusted for unusual items. Consider calculating what the net income would be if R and D expenses were capitalized and if the goodwill amortization expense is removed. Calculate net income after adjusting for any capitalized items that may not create tangible assets. Attempt to adjust net income if depreciation seems too low or too high. If the P/E ratio at first appears to be too good to be true, … it probably is.
Shawn Allen, CFA, CMA, MBA, P.Eng.
President, InvestorsFriend Inc.