Performance and Valuation Prime™ Chart
The PVP chart above reflects the real, economic performance and valuation measures of Harley-Davidson, Inc. (NYSE:HOG) 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 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 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, the as-reported financial statements and financial ratios of HOG do not reflect economic reality. The traditional ROA computation understates the company's profitability by incorrectly including certain items. The distortion of both profitability measures and valuation metrics of HOG is primarily driven by the inclusion of the firm's finance segment in traditional valuations, which is not a part of the core operations of the firm.
After adjusting for these issues and a host of other GAAP-based miscategorizations, Valens calculates HOG's Adjusted Return on Assets as 19% in 2015. In contrast, most financial databases show a traditional ROA of only 7%. Additionally, our analysis shows that HOG has an Adjusted Value to Earnings ratio of 23.2x, compared to the firm's traditional P/E of 11.4x. The profitability of HOG's operations and their equity's true value are therefore not what traditional metrics originally indicate.
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.
HOG's Adjusted ROA was 19% in 2015. This is not only greater than the 6.5% global weighted average cost of capital, it is also almost thrice that of the traditional 7% ROA being reported for the firm. The spread between HOG's Adjusted ROA and its traditional ROA is driven by an overstatement of their Total Operating Assets (the denominator, Asset).
This understatement in profitability is because the traditional ROA calculation fails to exclude the firm's finance segment (which accounts for only 12% HOG's revenues). This segment is not part of the firm's core operations, and artificially inflates its asset base, driving ROA lower. It is important to exclude a company's financial segments to better understand and determine the profitability of its core operations since we cannot use the same method of valuation when valuing financial segments (where it is more appropriate to use ROE versus ROA), considering that the financial segments of firms like HOG provide loans to customers of their core operations.
Ultimately, by adjusting for HOG's finance segment and using appropriate valuation methods, the returns earned by the firm through its core operations can be identified. This adjustment provides better investment analysis because it identifies the true profitability of the firm's core operations.
With everything considered, HOG appears to be far more profitable than what traditional metrics suggest. That is a major difference in context and concept for evaluating the firm's situation.
Growth in Adjusted Business Assets - A'
In the second panel of the 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 the Adjusted ROA, the growth rate explains a lot about management's intended strategies and even performance incentives.
HOG's Adjusted Asset growth has been volatile over the past decade. In 2007 and 2008, the company's Adjusted Assets grew by 6%-7%. Afterwards, the firm attempted to improve its operations in 2009-2010 by restructuring and through the divestiture of their MV Agustain business. In 2012, the firm successfully recovered their losses and improved their operations by focusing on international expansion, particularly around Asia Pacific, EMEA, and Latin America. Their Adjusted Asset growth is now at 5%-6% levels, close to their pre-recession levels.
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, and less excess cash (or non-operating investment balances). Meanwhile, the Adjusted Asset level reflects the total operating assets of the firm, necessarily adjusted for problematic accounting standards for reporting of the balance sheet. The Adjusted Asset level is the same as the denominator of the Adjusted Return on Assets calculation and the Adjusted Asset growth panel.
HOG is trading toward the low end of historical valuations relative to asset values with an Adjusted Value to Assets ratio of 4.1x, roughly the same as the firm's traditional 4.0x P/B ratio.
Considering that the firm's Adjusted ROA of 18% warrants an Adjusted Value to Assets ratio of 2.8x, the firm's Adjusted Value to Assets ratio of 4.1x indicates that the firm's equity may be overvalued by the market.
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 to 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.
HOG's as-reported forward P/E is at 11.4x, making their equity appear undervalued by the market. However, our analysis finds that HOG is trading at the middle of historical valuations relative to earnings with an Adjusted Value to Earnings ratio of 23.2x. The adjusted valuation indicates that HOG's stock is nowhere near as cheap as traditional valuations imply.
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 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 Harley-Davidson, Inc. can be seen once those distortions are removed. The firm is generating returns roughly thrice what most financial databases report. However, the adjusted valuations indicate that the stock may already be overvalued or is at least not as cheap as traditional valuations imply. With that context of corporate performance and market valuation, we have a far better means for evaluating HOG's stock price prospects.
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, Cheska Pablico. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" 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.