Performance and Valuation Prime™ Chart
The PVP chart above reflects the real, economic performance and valuation measures of Broadcom Corporation (BRCM) after making many major adjustments to the as-reported financials. The four panels explain the company's corporate performance and valuation levels over the past 10 years plus best estimates for forecast years based on quarterly financials and consensus estimates.
The apostrophe after the ROA', A', V/A', and V/E' is the symbol for "prime," which means "adjusted." These calculations have been modified with comprehensive adjustments to remove as-reported earnings, asset, liabilities, and cash flow statement inconsistencies and distortions.
For Broadcom, there are many failures of GAAP that lead to a low-quality earnings number and an unreliable balance sheet. One major issue is the failure to consistently require capitalization of research and development expenses. The natural "lumpiness" of the roughly $2.4bn expenditure results in earnings, margins, cash flow from operations, and return on assets that can fluctuate up and down materially from year to year, unlike economic reality.
GAAP requires R&D costs to be either expensed, or capitalized from acquisitions as in-process, or written off later. The goodwill and intangibles from acquisitions compound the issues when research and development expenditures are involved. For Broadcom, goodwill in the $3bn to $4bn range and intangible assets ranging from $600mn to +$2bn also create material inconsistencies.
These create inconsistencies when comparing one company to another, and from comparing a company to itself from year to year. It's worth noting that the handling of R&D under IFRS is even more of a problem than under GAAP as it can allow even more wiggle room for judgment by management from year to year as to what is capitalized and what is expensed.
As it stands, even the venerable statement of cash flows is full of distortions and the expensing of R&D is just one of the many issues. When SFAS 95 implemented the statement of cash flows in the late 1980s, three of the seven FASB members voted against it. It's almost unbelievable, and yet it's written into the actual statement of financial accounting standard. One would think that, for such a major change in financial statement reporting and disclosures, you'd require a unanimous vote or at least a super majority.
Analysis shows that GAAP cash flow from operations was $1.93bn for 2014 when, in economic reality, BRCM's adjusted operating cash flows were closer to twice that at $3.77bn.
Return on Assets Prime: Real Economic Profitability in the ROA'
The top panel of the chart shows ROA' (ROA prime, a.k.a. adjusted return on assets). This measure is comparable from year to year and across peers as it "cleans up" the aforementioned GAAP accounting issues to provide consistent analysis.
The ROA' panel of the Performance & Valuation Prime™ chart demonstrates the firm's annual cash flow returns over a decade of history. Two forecasted years are shown after the last full fiscal year ("LFY"), both marked with an "E" to indicate that they are estimates. Calculations are based on publicly-available consensus analyst forecasts of firm sales, net income, capital expenditures, and other information. These are Valens' assessment of what consensus analyst estimates suggest for forecasted ROAs.
At Broadcom, Adjusted Return on Assets (ROA') has been and continues to be forecasted in the 18% to 21% range, not the 6% to 7% range as reported by most financial databases. The company may have spent significantly on acquisitions in the past; however, it is a serious cash flow generator now. BRCM's ROA' is well above the global corporate average ROA' of 6% and the USA corporate average of 9%. These are all real, not nominal, numbers, undistorted by varying levels of inflation from year to year or country to country.
Broadcom has doubled its ROA' from the 8% to 10% range five to six years ago to the 18% to 21% range now. In reality, BRCM is not a low operating cash flow return company. It is a massive cash flow generator that has been investing heavily in itself. That is a major difference in context and concept for evaluating Broadcom's situation.
Growth in Business Assets - A'
In the second panel of the four-panel chart, Asset' Growth stands for "Asset Prime Growth" and is the real annual growth rate of the cleaned-up and properly adjusted asset base of the company. This metric shows the management team's propensity to reinvest or disinvest over time. When viewed in context of the ROA', the growth rate explains a lot about management's intended strategies and even performance incentives.
Asset' Growth is a real metric, meaning it is adjusted for changes in currency inflation or deflation levels. Asset' Growth can come in the form of organic growth, where a firm simply purchases new assets through capital expenditures or invests in itself through research and development. Asset' growth can also come from acquisitions. Negative growth can come from divestitures, or simply assets aging and leaving the books without replacement. If a firm shows capital expenditures that are just enough to replace assets that are aging, the chart would show a zero growth rate.
Broadcom has shown a history of significantly investing in the firm, which is the right thing to do when ROAs are well above and expected to remain above the opportunity cost of capital. Asset growth rates range around 10% and much higher for most of the last decade. This is significantly above the GDP growth rates as well as the U.S. corporate average growth of 3% to 9% over the last 10 years. By reinvesting in such high ROAs, the firm is compounding its returns. Valuations reflect that positive performance.
Valuation Relative to Adjusted Assets V/A'
The third panel of the four panel chart shows the adjusted value to assets ratio. V/A' is a calculation comparing the enterprise value (V) of the company to the asset level (A'). The V is the market capitalization of the company plus the total debt of the company, including off-balance sheet debt. The A' reflects the total operating assets of the firm, necessarily adjusted for problematic accounting standards for reporting of the balance sheet. V/A' can be thought of as a very "cleaned-up" price-to-book metric. The A' is the same as the denominator of the ROA' calculation and the asset growth panel.
Throughout 50+ years of corporate performance and valuation history across industries and around the world, there has always been a tremendously strong relationship between ROA' levels and V/A'. The stock market more highly values companies that show a higher ROA' when those measures are adjusted for accounting issues. Note that doing this type of analysis using as-reported figures does not result in such an obvious relationship. The departure of GAAP and IFRS accounting from economic reality simply makes the analysis less reliable and far less useful.
Firms that generate higher cash flows relative to their investment base experience higher market valuations relative to their investment base. The historically strong relationship between valuation levels and firm "quality" - between V/A' and ROA' - creates an opportunity for evaluating a firm's valuation level very quickly. The empirical, observed relationship between quality and valuation when measured this way is amazingly intuitive and logical.
The market tends to value V/A' at "1" when the firm generates an ROA' at the opportunity cost of capital. In other words, firms trade near their "book value" when their returns are merely at corporate averages. When the firms' returns sustain double the opportunity cost of capital, the valuations tend to be double the book value, and so on. Again, the observation is extremely intuitive and even somewhat serves as a proof of the necessity for "cleaning-up" the accounting data. Relationships between traditional price-to-book metrics and other return metrics are seldom so logical.
Interestingly, there appears to be a "floor" for valuations, regardless of how negative returns can go. V/A' tends to not fall substantially below 0.6 times assets unless there is a risk of credit default or bankruptcy. When V/A' is far above the traditional relationship to ROA', it does not necessarily suggest overvaluation. It suggests that investor forecasts for future ROA' improvement and growth could be far higher than traditional firms, such as in earlier growth stages of companies.
As Broadcom's returns rise, and proper investment growth compounds those returns, we see the asset multiple (V/A') having risen consistently. A firm with an ROA' of 18% when the global corporate average is 6% certainly deserves a multiple three times its asset base, which is almost exactly what we're measuring now. However, the continued investment growth ought to drive a higher multiple than the ROA' alone would deserve. The market seems to have not factored that in yet. A V/A' ratio of 3.2x is actually low relative to other similar firms. In essence, Avago (NASDAQ:AVGO), which is in the process of acquiring Broadcom, may have gotten the company at discount since the price it paid for Broadcom reflects the company's strong profitability, but not its growth opportunities.
Valuation Relative to Adjusted Earnings V/E'
BRCM's as-reported P/E is slightly over 20x. Were it not for superior analysis, this might suggest a high valuation given long-term P/E averages of 15x to 17x. That said, by making adjustments, we find that BRCM has approximately a 15.8x V/E' (Valens' cleaned-up enterprise value to adjusted earnings ratio, also known as an "economic P/E"). The value numerator is the same as that in the adjusted value to assets ratio. The adjusted earnings in the denominator is the same as the number as in the ROA' calculation.
While the adjusted earnings multiple has risen significantly since its single-digit lows a few years ago, a multiple of 15 times still means Avago did not overpay for the company if the firm continues to generate such strong cash flows and healthy reinvestment rates.
As-reported financial statement information and financial ratios, which make up most of the publicly available financial databases, do not consider the extent to which distortions, mis-categorizations, and misclassifications cause as-reported financial statements to depart from economic reality. Even the venerable "statement of cash flaws" - pun intended - is horribly distorted, as many items in the statement of cash flows are actually non-cash related. What is deemed cash flow from operations, investing, and financing activities are inconsistently booked from company to company and even just from year to year at an individual company. The distortions are material and directionally changing, and the mis-measurements that result are decision-changing issues.
A far better picture of the economic reality of Broadcom Corporation can be seen once those distortions are removed. The firm is generating returns at three times corporate averages. It is successfully reinvesting in itself at levels far above the anemic GDP growth rates seen around the world. Meanwhile, relative valuations of BRCM remain low versus companies of similar quality and growth. With that context of corporate performance and market valuation, we have a far better means for evaluating Broadcom's prospects, and if Avago overpaid or underpaid for the acquisition it has made.
Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article along with the lead analyst, Caroline Cervillon. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.
Disclosures: Officers of Valens Securities and Valens Equities are engaged and have positions in securities of Broadcom Corporation, BRCM, as of the date of this report.
Disclosure: I am/we are long BRCM.
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.