# Evaluating The Quality Of Earnings

by: Dane Bowler

It is common knowledge that for any given company, it is better to buy it at a lower P/E ratio. However, valuation gets far more difficult when comparing different companies and especially when comparing different industries. If we were to look at an established retailer trading at a P/E of 15 and a vehicle manufacturer trading at a P/E of 12, which is the better value? How would one even go about comparing the two? These are perplexing questions, but the answers will become more apparent as you read this article. We will detail the foundational techniques for analyzing and justifying disparate valuations.

Understanding valuation

Before we articulate the analytical techniques, we must establish a baseline understanding of valuation. Here is a formula for calculating a company's earnings based on various operating parameters.

Earnings = Market Cap X {[Cash yield + (Spread X Leverage)] X 1/P/B)} - (acquisition fees, G&A and other non-operating expenses)

As an equation this may be ambiguous, so allow me to provide an example for clarity. These numbers are not representative of any particular company, but rather chosen for mathematical simplicity.

Market Cap: \$2,000mm

Price/Book: 4

Investment cash Yield: 10%

Weighted average cost of capital: 5%

Leverage: 3X

Annual fees: \$10mm

If a company has a market capitalization of \$2B and a price to book of 4, it has \$500mm of equity available for investment (some or all of which may already be allocated). If said equity is invested in the company's operations at an annual yield of 10%, this contributes \$50mm to earnings. This \$500mm is also levered 3 to 1 such that it has an additional \$1.5B to invest. Assuming a weighted average cost of capital of 5% and the same 10% yield on investment, this leaves a spread of 500 basis points. The leveraged investments contribute another \$150mm to earnings. The aggregate \$200mm minus the \$10mm spent on fees and other costs leaves total earnings of \$190mm. Dividing the market cap by the total earnings shows a P/E of 10.53.

Why is this useful? Well, breaking down earnings like this affords attribution of earnings for further analysis. The attribution of earnings is the basis of comparison across companies and industries.

Two companies with the same price/earnings ratio are not necessarily equally good investments. They may be differentiated by the quality of their earnings. Looking at earnings attribution is the starting point for determining quality.

There are five aspects that contribute to a low price/earnings ratio:

1. High leverage
2. Low price/book
3. High investment cash yield
4. Low weighted average cost of borrowed capital
5. Efficient operations

Each of these comes with substantial risks and/or benefits. While all of these benefit earnings, the importance of attribution is to determine the QUALITY of earnings. In other words, once we know the current P/E ratio, we want to ensure the security of it and the potential for it to improve. The below analysis of each attribution is under the assumption that all else is equal including P/E.

High Leverage

Among two companies with the same P/E, the one with higher leverage will tend to have a more dangerous risk profile. This is not a desirable earnings component.

Low Price/book

Having a low P/B tends to protect an investor's principal. This component is preferable among two companies with equivalent P/E.

High Investment Cash Yield

This can either be good or bad. The ability of a company to invest further capital at accretive rates bodes well for growth, but it may also make the space more desirable to competition. If a company is relying on a superb IRR make absolutely certain that it has a unique angle or that there are large barriers to entry. Diminishing rates of return is a substantial risk for those getting above market yields on investment.

Low Weighted Average Cost of Borrowed Capital

This is also a mixed bag. It is good if and only if it is sustainable. Low cost of debt derived from excessive use of variable rate debt in the current low rate environment could prove to be a liability, while low rates locked in for a long duration are a valuable asset.

Efficient Operations

Certain companies seem to be able to accomplish the same operations more efficiently than others. This sort of efficacy is usually intangible, yet quite valuable.

Summary and conclusion

We began with a question: Is the established retailer trading at a P/E of 15 or a vehicle manufacturer trading at a P/E of 12 a better value? The answer lies in earnings attribution. If the vehicle manufacturer is getting its earnings from exceptionally high rates of return on leveraged capital, its earnings may not be of quality. The ensuing competition and enhanced tail risk just might be enough to make the extra earnings return on invested capital not worth it. Investment is all about weighing the tradeoff between quality of earnings and size of earnings. With sufficient patience and awareness, the equanimous investor can attain both.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.