Finding Value (or Not) Beyond Net Income

Finding Value (or Not) Beyond Net Income

The Value of a an established corporation should normally be reflected in its Net Income. However, there are many cases where value has been created but it is not (yet) showing up in net income, even after adjusting net income for any unusual losses or charges.

If a company is trading on its net income value, an investor may be able to identify a bargain if he or she can discover hidden value that is not being reflected in net income.

A more frequent situation is where a company appears to be trading at an unreasonable multiple of net earnings. Companies often ask investors to ignore net income and instead focus on various measures of cash flow or cash distributions or assets. In these cases the investor needs to be able to understand why the company is worth more than its earnings would suggest. Understanding this will allow investors to avoid companies that are in fact over-valued. Investors will be better able to recognize when net income may indeed be under-stating the value of the company.

Companies can be creating hidden value in all three components of the Cash Flow Statement, Operations, Investments and Financing.

Hidden Value in Operations:

GAAP net income shows up in the operations section of the cash flow statement. If net income is under-stated this can create hidden value. Examples of under-stated net income include.

Deferred or Future Income Tax: This occurs when the accounting income tax is higher than the actual income tax. It could be argued that this is a phantom expense. It represents a tax expense that will be due in the future. However, growing companies are often able to continually defer a growing amount of income tax. Deferral of income tax always creates at least some hidden value due to the time value of delaying income taxes. In some cases the entire amount of deferred income tax is essentially hidden earnings since the deferral may be virtually permanent. On average, it’s probably prudent to add back about half of the deferred income tax as additional adjusted income.

Expenses that create future benefits. Customer acquisition costs to acquire customers that are expected to remain as customers for many months or years are often expenses even though they create future benefits. Examples include commissions paid to acquire cell phone, insurance, and cable T.V. customers and apartment rental incentives. Some companies do defer these expenses. It is in cases where they are expenses rather than capitalized or deferred that hidden value may be created. Unfortunately is is difficult to know how much of these expenses (net of tax) should be added back to create a more realistic adjusted net income. Some analysts attempt to reconstruct the income statement as if these expenses had been capitalized and then amortized over a reasonable period of years.

Depreciation that is greater than maintenance capital spending. In some industries that use long-lived assets, there may be little maintenance capital spending required. In that case most of the depreciation expense truly is a non-cash expense and should be added back to net income. However, investors should be cautious because companies may claim all of the depreciation is non-cash when in fact much of it is being spent on maintenance capital spending. The portion of depreciation that exceeds annual average maintenance capital spending is creating value and should be added back to adjusted net income.

Research expenses are usually conservatively expensed under GAAP even though they are expressly designed to benefit future years. As long as the research is creating something useful, this definitely creases a hidden value not reflected in net income.

Hidden Value In Investments

In certain situations it may be possible for a company to buy assets for say 50 cents on the dollar. Since the asset is recorded at cost the hidden value that has been created does not immediately show up. Instead it will show up in future years through a higher return on equity. Energy Royalty Trusts may be benefiting from this now. Oil and Gas assets are worth more to Trusts than they are to taxable corporations. Therefore if there are many corporations selling assets, then the Trusts may be getting assets for cents on the dollar and creating hidden value. This could end badly if the supply of assets changes such that their are more Trusts buying than Corporations selling. The Trusts would then not be able to buy for cents on the dollar. Another example of where this occurs is when a public company can buy and fold in small private firms. The private assets may suffer from a liquidity discount and it may be possible, for a publicly traded company, to buy them for cents on the dollar. I believe that this has been part of the success of Stantec and of First Services Inc.

Hidden Value in Financings

There is a technique that can be used when a companies shares are over-valued due to excessive hype or attention toward the stock. In this situation, the wise company tries to sell substantial equity at the high price, ostensibly to fund expansion. The result is that the book value per share rises. The company can use some of the funds raised to pay down debt. Even if the excitement dies down, the increase in book value per share can provide a floor of value under the shares. In the end shareholders would have been better off selling at the peak. But the company may brag about how its share price or book value per share rose over the years (ignoring that the spike in share price that creates this opportunity).

I believe that this phenomena was at work near the IPO of Boardwalk Inc. It also clearly occurred with FairFax Financial which created a phenomenal 31% annual increase in book value per share, in the 18 years ending 2003. This is exceptional by any measure. But it was created not simply by retained net income. Rather a good portion of it was created by selling shares, when it had the chance at over 3 times book value and later buying shares back when it had the chance at less than book value. During this period Fairfax had a very good annual average ROE of 16.0% but the additional 15% per year increase in book value per share apparently came from shrewd sales of stock and buy-backs at opportune stock prices. Investors would have been far better off to have sold when the share price peaked. This is a type of hidden value that did not “run through” the net earnings. But investors cannot expect to benefit from this in the future, since it depends on selling shares at inflated prices. It does indicate an astute management. Most managements like that of Nortel were , frankly, too stupid to sell substantial shares when their stocks were flying ridiculously high. They actually believed that their stock deserved to be that high when a more financially literate management would have known better.

This phenomena may also be occurring today with various Income Trusts, including Royalty Trusts. On average they are paying out double their earnings and so may be over-valued. (they would claim distributable cash flow is at lest double earnings, and only time will tell if their disrespect of GAAP is justified). Possibly they are using the cash from over-priced unit sales to shore up the balance sheet. Capital spending that is required to merely maintain operations could be passed off as growth oriented capital spending. It certainly increases book value per unit. However, if units are indeed over-valued then this will eventually become apparent and unit prices will fall.


Shawn C. Allen, CFA, CMA, MBA, P.Eng.
President, InvestorsFriend Inc.
October 9, 2004