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Strategies & Market Trends : Graham and Doddsville -- Value Investing In The New Era -- Ignore unavailable to you. Want to Upgrade?

To: porcupine --''''> who wrote (174)	4/16/1998 12:57:00 AM
From: Berney	Respond to of 1722

Porcupine, WOW -- what an undertaking! You know, I fell in love with accounting in college because it only had four concepts and nine principles, and, after that, it was up to the practitioner. Obviously, it has gotten somewhat more complex since the 70's. And then, I was introduced to the world of taxation. The basic accounting principles are that we desire to match our current revenue and costs. Taxation accounting says that we want our costs now, our revenue in the future, and to Hell with matching. Taxation accounting has incredible implications on a company's net income and free cash flow. Consider for a moment, that a corp the size of an IBM is paying (supposedly) a marginal tax rate of 40% (including state taxes) on each incremental dollar of net income. Of course, share buy backs and dividends are not deductible expenses. Also consider, that once upon a time tariffs were the main source of revenue to the operations of this country. And then, the concept of free trade was developed. And then, corporate taxes was the main revenue source. And then, individual taxes became the main revenue source. And then, a half a century ago, payroll taxes became the main source of revenue. An issue to consider on this evening. Can you possibly imagine the increased revenue to our Treasury if IBM et al properly accounted for their income? I do not fault them, but applaud them. For as a supreme court justice long-ago stated: "Taxes are enforced exactions and not voluntary contributions and to demand more in the name of morals is mere cant". IBM can obviously afford the best minds in the field of taxation. They are, in fact, substantially enhancing shareholder value by postponing the taxation of current revenue. Berney

To: porcupine --''''> who wrote (174)	4/16/1998 9:28:00 AM
From: Daniel Chisholm	Read Replies (1) \| Respond to of 1722

porcupine, re: EVA, IBM, ROE: Great post! Thanks so much for this post, it pulled together a lot of "GAAP fixups" for me. In particular, how and why goodwill and R&D ought to be realistically treated. I haven't recently gone over your EVA stuff, but I did have one question about it that has bugged me since I read your analysis of Novell. That is, your input of "x% return on equity capital". I understand that one ought to assign a fair return to the cost of equity capital, however after an EVA analysis is done, one arrives at an excess/deficiency of return. Why not initially assign a "cost of equity capital" of 0%, then run the numbers, and then have a residual profit or loss, which would belong to the company's shareholder equity. Then, one would have to consider whether that return on equity capital indicated that the company was or was not well run. Surely a sound, predictable low-risk company could legitimately provide lower returns on equity capital, and still be considered to be a sound, "value adding" company. Whereas a riskier company ought to earn a higher return in order to justify its worth. I guess what I am saying is that ultimately one ought to apply a risk-based weighting to the cost of equity capital, and that I think this should not be done up front, but rather the raw number obtained at the end of the process should then be considered against the analyst's best analysis of risk, and only then should a decision be made as to whether or not management is producing net value for shareholders' capital. Once again, thanks for an A-1 article. Keep up the great work! - Daniel

To: porcupine --''''> who wrote (174)	4/16/1998 5:50:00 PM
From: porcupine --''''>	Read Replies (4) \| Respond to of 1722

IF the price were right ... A reader writes: > Forget issues of current value and pricing. How many of the DJIA > stocks would you feel comfortable buying IF the price were right? All but MO, which eventually will be sued by everyone in the world. porc --''''>

To: porcupine --''''> who wrote (174)	4/18/1998 6:15:00 PM
From: porcupine --''''>	Read Replies (4) \| Respond to of 1722

Wayne responds to: "Is the Market Overvalued? -- EVA, IBM, and ROE." Reynolds, I enjoyed your latest version of GADR. It was one of your best yet. You identified a number of interesting accounting issues for investors to think about. I believe we are on the same page on most of them. Where we disagree is in the valuation conclusion that an investor might draw from the questionable measurements GAAP book values and the ROE figures that result. I agree that they are suspect, but disagree with your conclusion. First, in order for investors to appreciate what I am saying, it is necessary that they be familiar with the valuation models that I use. They are similar but not identical to the ones that are commonly used on Wall St. in private transactions. Some investors (including yourself) may not agree with them or with the conclusions that are a result. These models primarily use current and future Free Cash Flow estimates to obtain a value. In almost no instance is either the Book Value or ROE used as an input to the models. (One exception is for financial services companies where most of the assets are liquid and more accurately measured and the earnings are more volatile.) So NO valuation changes would occur even if we had accurate replacement value figures or modifications in the accounting rules that better reflected reality on the ROE and book value front. People refer to ROE because high return businesses generate greater amounts of FCF than low return businesses. It is mostly just a profitability guideline. No one that I am aware of has stated that PEs are inflated due to ROE measurements. What they are saying is that Free Cash Flow levels are not as high as the stated ROE would lead one to believe and that current profit margins are higher than the sustainable level. That stated, I agree that the GAAP book values are highly questionable and essentially useless. As a result so is the standard ROE measurement. I said as much in my refutation of Abby Cohen's "Investors Should Relax" article (that appeared in Barron's) in a Market View of mine a couple of months ago. It was ABBY that suggested that PE ratios of twice the long-term average and 50% above the all time high for non-depressed earnings were partly justified by the high reported current ROE. I suspect that most analysts (including myself) point to the high ROE not as an absolute measurement to be compared to the past or as a measurement of value, but as one of many indications that corporate profitability is currently above average. Where we are in the business cycle is significant to an accurate business appraisal. As margins increase almost all the additional profits become free cash. Hence if they are running above average or at a level of questionable sustainability we need to know that. The appraisals could be very wrong otherwise. Similarly, when the economy is running below average, free cash flow virtually vanishes and we would want to know that too. To address this issue I use a lot of macro-economic statistics, stated ROE, a measure of ROE that uses only recent retained earnings and the growth they have produced, distributions of income between workers and business, and several other indicators. None is truly accurate due to the many complexities, but they serve my purpose. All currently indicate the existence of above average returns. In some cases significantly. That is enough for me. I have heard of no one that has suggested otherwise. This begs an answer to the question of what is and what is not sustainable on the margin front. Intuitively one could look at history or even this full business cycle and come to the conclusion that current margins will eventually fall. These levels have never been sustained before. Smoothing this cycle into normalized earnings suggests the same. It also seems unlikely that the lowest level of unemployment in 25 years, high capacity utilization etc...is now the permanent state of affairs with the U.S. to never again experience a slowdown. I suspect that this reasoning is not acceptable to you. To understand the issue and answers better it then becomes necessary to understand where I believe the higher margins are really coming from. There is a relationship between personal savings levels, household credit expansion, income distribution and corporate returns in the short term. The current high margins are to a large degree the result of some of the lowest personal savings levels in history, an enormous expansion of credit, and an income distribution slanted towards business. This data is all available in the public Federal Reserve statistics. The relationships should intuitively be obvious. In effect, what is going on now is the same thing that happens in every business cycle except to a larger degree. Credit expands, savings levels fall, and corporate profit margins rise. This is unsustainable though. You simply cannot continue to transfer money from people to business forever. Eventually, either personal incomes rise more rapidly than the debt accumulation (wage pressures), the prices of the goods and services fall (competition for market share) or all the customers go broke. The margins thus decline. In this particular business cycle there has also been a set of international macro-economic circumstances that has prevented this process from being short circuited earlier from both a savings shortfall or inflation perspective as has also happened in the past. I will present an article by a leading Austrian School economist that discusses much of this in a manner that is clearer than I have been able to express it over the last year or two. It will appear in my next Market View in May. There is also a very good discussion of the monetary and credit component to all of this in the latest issue of Grant's Interest Rate Observer. In conclusion, it has been the higher ROE that has been used by some Wall St. bulls to help justify prices that are twice the long-term average and 50% above similarly favorable economic circumstances. We agree that the margins are not as high as they look from a ROE perspective. The individual companies I have examined free cash flow for indicate that. Therefore the prices are as high as the PEs suggest. (Twice as high as the average and 50% above the other "new eras") The free cash that is usually associated with high ROE in casual valuations is not there because the ROE is wrong. Where we disagree is in whether there are relationships between the cost of capital, savings, credit expansion etc...the current REAL ROE, and the sustainable of all of it. I do not know of a way to accurately measure just where REAL ROE is in relation to the past. It is higher than average though based on everything I can think of examining. I think that this is not sustainable. Therefore, I believe that paying twice the long-term average PE ratio understates the true amount of overpayment relative to the past. From all of this discussion it is certain that we are debating the degree of overpayment relative to the past. As a result we must agree that future stock returns will lower than in the past. We are paying much more for the income streams now than ever before. It is just a matter of how much more and how much lower future returns will be. My contention (and I think most other "valuation bears") has been the opposite of what you are implying. If the ROE measurements that we now see were both REAL and sustainable, I would be less concerned about the valuations because the businesses would be worth more. We already agree that the ROE is NOT REAL. Note: This discussion excludes the effects on free cash flow of the non-expensed stock option repurchases of which I have written about often. This is another key element of not so obvious overpayment in addition and related to the above. The Missing Book Value Part of your discussion talked about what could be called "missing book value" based on earnings reported in the Value Line. This may help clarify the issue to some degree. There were accounting changes related to post-retirement benefits put in place in the early 90's. Companies must now charge earnings in the present for the promised health care expenses to be made in the future for retirees etc.. That was not the case prior to then. Many companies made massive charges to their earnings in both 1992 and 1993 for the future liabilities accumulated up to then. This literally knocked many hundreds of dollars of book value off the DOW without effecting cash or assets used. IBM was among them. VL makes no discussion of any of this. The book value just disappears. These liabilities are also a soft number. They are based on assumptions about medical inflation rates that may prove lower than previously anticipated. This leaves us wide open to some accounting chicanery in the future. If the rate of medical inflation remains low, many companies will be tempted to reduce the value of the liabilities on their balance sheets and flow the reduction through as increased current earnings. They were non-cash charges when they were made and they will be non-cash earnings if the liabilities are reduced. Whatever the true cost of these liabilities turns out to be, they will eventually be REAL CASH expenditures in the future even though they won't be expensed in the year they occur. Thus they are related to any intrinsic value calculation. Keep in mind they have already been charged to earnings and VL makes no mention of any of this. I can also assure you that the analysts that said not to pay attention to those one-time charges in 92 and 93 won't tell you pay attention to the non-cash earnings that may occur in the future or the cash expenditures that really do occur in the future. It is a symptom of the speculative nature of the environment and vested interests of Wall St. Lastly, some companies borrowed money in the last year or two and repurchased shares at significantly above book value in amounts that are greater than earnings - dividends. This also reduces book value. R&D and Software I tend to agree with you that both R&D and software have value as an asset. That value is based on the income stream they generate and the money invested to create it. However, IBM was not paying for the assets per se. It was paying for the future income streams almost exclusively. (That is the case in ALL intangible purchases. You are not buying an asset per se. You are buying a stream of earnings and above average returns that you believe a Name or Brand will produce. You can therefore be wrong and the asset will vanish. Therefore there should be some separation of the asset type - tangible or intangible.) But I also believe that if accounting rules are changed to reflect your and my view that software and R&D are assets, then R&D should become a capital expenditure and software should be depreciated. Free Cash Flow would remain unaltered over time as a result as so would valuations. (I grant the complications in measuring this all) I believe "software as an asset" should be depreciated for several reasons. The rapid change of software tools and languages and the constant need to re-code for the next version makes the prior versions obsolete and valueless over time without continued expenditures. Therefore the increase in the value of the intangible assets that occurs in many cases is related to the continuing and progressively larger expenditures required for upgrades and new software applications. This means the money used is not Free Cash. It also means that the asset value will eventually disappear if R&D is halted. There may be some intangible value related to prior experience with the use and development of prior versions, but it is no different than is the case with the development of the typical tools of the past that are depreciated. This has always existed. I can give you a list of 50 large software companies whose "Asset" virtually vanished in the last 10 years because the latest version did not cut it or was replaced by a better software from a different company. In summary, if recording these things as an asset better reflects reality it should be recorded with an asterisk. These intangibles are just not of the same quality as a brand name like Coke or Campbell. They are also different than buildings, plant etc... The values disappear all the time in software. As far as the valuations are concerned, I don't care how it all is expensed, depreciated, recorded etc... I am looking only at the bottom line cash and income streams. These would essentially be unaltered over the long haul no matter how they are accounted for as long as it reflects reality to the best of the accounting community's ability. Acquisitions Instead I think we agree that companies have been buying each other more often instead of building plants etc... like they used to. Hence there is much more goodwill on the books. The only point I'd like to make here is that if Free Cash Flow is equal to distributable earnings, then acquisitions are a form of capital spending and must be subtracted. VL does not include these things in the capital expenditure numbers that it publishes. As a result, comparisons of prior capital expenditures to the present using published data from VL understates current capital spending and overstates FCF unless you include takeovers, mergers etc... Trying to account for all the transactions that have occurred to get to some aggregate figure is a monumental task with all kinds of complexities because of the one shot nature of these expenses vs. the usual smoother nature of standard capital spending. It is essentially a waste of time other than to know that VL is not reflecting reality in this area on the free cash front. For myself, I always try to make estimates of these expenditures in my valuations. The April GADR was awesome. My brain is sizzling as we speak thinking about the accounting issues you have helped highlight and clarify. Wayne