Performance and Valuation Prime Chart
The apostrophe after ROA', Asset', 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, liability and cash flow statement inconsistencies and distortions. To better understand the PVP chart and the following discussion, please refer to our guide here. The PVP chart above reflects the real, economic performance and valuation measures of Qualcomm Incorporated (NASDAQ:QCOM) 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 problem with Generally Accepted Accounting Principles (GAAP) is that they create inconsistencies when comparing one company to another and when comparing a company to itself from year to year. By making adjustments, we aim to remove the financial statement distortions and miscategorizations of GAAP. Some of these can be automated through consistently applied formulas. However, many must be made manually. Manual adjustments that cannot be automated include mergers and acquisitions accounting, special charges, business impairments, and others. The practice of creating consistent, apples-to-apples comparable measures of financial performance is often considered either tedious or overly complex by even seasoned financial analysts.
Under GAAP, as-reported financial statements and financial ratios of QCOM do not reflect economic reality. The traditional return on assets computation understates the company's profitability by incorrectly including certain items. The distortion of both profitability measures and valuation metrics of QCOM were driven by the inclusion of goodwill ($5.5bn), which inflates the firm's assets, and by incorrectly expensing items like R&D ($5.5bn) and operating leases ($99mn) rather than treating them as part of the company's investments.
After adjusting for similar issues and a host of other GAAP-based miscategorizations, we calculate QCOM's Adjusted Return on Assets as 22% in 2015. In contrast, most financial databases show a traditional ROA of only 9%. The profitability of QCOM's operations and equity's true value are therefore not what traditional metrics originally suggest.
Adjusted Return on Assets - ROA'
The top panel of the chart shows the firm's Adjusted ROA (a.k.a. ROA', or ROA Prime). This measure is comparable from year to year and across peers as it "cleans up" the aforementioned GAAP accounting issues to provide consistent analysis.
Qualcomm's Adjusted ROA was 22% in 2015, which is not only 3x the U.S. average cost of capital, but also 2x its traditionally reported ROA of 9%. The spread between QCOM's Adjusted ROA and its traditional ROA is driven by an understatement in the company's Adjusted Earnings From Operations (the numerator, Earnings'), and an overstatement of their Adjusted Total Operating Assets (the denominator, Asset'). Earnings are understated because the traditional calculation of net income does not recognize R&D expenses and operating leases as part of the company's operating investments. The incorrect deduction of these items makes it near impossible to objectively compare the firm to its peers and even to its own historical performance. Our adjustments resolve the accounting issues between the expensing and capitalization of certain expenses.
Additionally, by adjusting for the firm's $5.5bn goodwill, returns earned by QCOM through its operations can be identified. This adjustment provides a better investment analysis because it separates the firm's profitability into: 1) organic Adjusted ROA, which indicates how well management executes the business, and 2) acquisitive Adjusted ROA, which shows how well management does when they acquire a business. With everything considered, QCOM appears to be more profitable than what traditional metrics might suggest. That is a major difference in context and concept for evaluating the firm's situation.
Growth in Business Assets - A'
In the second panel of the four-panel chart, Asset' growth stands for "Asset Prime Growth" (or Adjusted Asset 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 divest over time. When viewed in context of Adjusted ROA, the growth rate explains a lot about management's intended strategies and even their performance incentives.
QCOM experienced 19%-22% Adjusted Asset growth in 2007-2008. In 2009, QCOM's Asset' growth slowed to 4%, a result of the U.S. debt crisis. The Adjusted Asset base then grew by 17%-19% in 2010-2011 before slowing to 12% in 2012. More recently, Adjusted Asset levels grew 15% in 2013 before falling to 9% levels in 2015.
Valuation Relative to Adjusted Assets - V/A'
The third panel shows the Adjusted Value to Assets ratio (V/A'), a "cleaned-up" Price-to-Book metric that compares the Adjusted Enterprise Value (V') of the company to its Adjusted Asset level (A'). The Adjusted Enterprise Value is the market capitalization of the company plus the total debt of the company, including off-balance sheet debt while the Adjusted Asset level reflects the total operating assets of the firm, necessarily adjusted for problematic accounting standards for reporting of the balance sheet. Adjusted Assets is the same as the denominator of the Adjusted ROA calculation and the Adjusted Asset growth panel.
The firm's 22% Adjusted ROA in 2015 indicates that an Adjusted Value to Assets ratio of 1.7x is too low considering that 21% Adjusted ROA levels had valuations of 3.6x in 2010. In addition, a 23% Adjusted ROA firm merits at least a 3.5x Adjusted Value to Assets ratio, much higher than the firm's traditional P/B of 2.2x.
Valuation Relative to Adjusted Earnings - V/E'
In the fourth panel, we have another perspective of valuation to help triangulate the market's embedded expectations for company performance. We always want to know what is "priced-in" to the stock price. In this case, Valens evaluates the Adjusted Enterprise Value (V') of the firm relative to their expected Adjusted Earnings (E') for the next year. Adjusted Earnings are earnings resulting from the company's core business operations, regardless of how it is financed, and adjusted to its current dollar value. This is adjusted to eliminate accounting distortions and shenanigans, and enhance comparability across different companies, industries and geographies, to determine potential mispricings. The Adjusted Enterprise Value (V') numerator is the same as that in the Adjusted Value to Assets ratio.
Qualcomm's as-reported forward P/E is at 10.2x, indicating that the firm's equity may be undervalued (since long-term P/E ratios average around 15x-17x). Our analysis finds that QCOM has approximately an 11.7x Adjusted Value to Earnings ratio, higher than the firm's traditional P/E but still lower than the industry's P/E averages.
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, miscategorizations, 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's 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 mismeasurements that result are decision-changing issues.
A far better picture of the economic reality of Qualcomm Incorporated can be seen once those distortions are removed. The firm is generating returns more than twice what most financial databases report, but has adjusted valuations that are close to traditional valuations. With that context of corporate performance and market valuation, we have a far better means for evaluating QCOM's prospects for the future of its stock.
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 "fundamental forensic" analysis, particularly in corporate performance and valuation.
Disclosure: I/we 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.