Performance and Valuation Prime™ Chart
For context, the PVP chart below reflects the real, economic performance and valuation measures of Oracle Corporation (NYSE:ORCL) after making many major adjustments to the as-reported financials. This chart, along with all of the charts included in this article, as well as the detail behind the graphics, can be found here.
The four panels above explain the company's historical corporate performance and valuation levels plus consensus estimates for forecast years as well as what the market is currently pricing in, in terms of expectations for profitability and growth.
This analysis uses Uniform Adjusted Financial Reporting Standards (UAFRS) metrics, or adjusted metrics, which remove accounting distortions found in GAAP and IFRS to reveal the true economic profitability of a firm. This allows us to better understand the real historic economic profitability of a firm as well as allows for better comparability between peers. To better understand UAFRS, please refer to our explanation 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 using UAFRS, 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 ORCL do not reflect economic reality. The traditional ROA computation understates the company's profitability by incorrectly including certain items. The inclusion of goodwill ($34.1bn) and the company's massive liquidity profile (without adjusting for excess cash) inflates ORCL's assets, resulting in a distortion of performance measures.
After using UAFRS to adjust for similar issues and a host of other GAAP-based miscategorizations, Valens calculates ORCL's Adjusted Return on Assets as 28% in 2015. In contrast, most financial databases show a traditional ROA of only 9%. Additionally, analysis shows that ORCL has an Adjusted Forward P/E of 15.4x, when the firm's traditional forward P/E is smaller at 13.5x. The profitability of ORCL'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 UAFRS-based ROA (a.k.a. ROA', or ROA Prime). This measure is comparable from year to year and across peers as it uses Uniform Adjusted Financial Reporting Standards which "clean up" the aforementioned GAAP accounting issues to provide consistent analysis.
As discussed earlier, Oracle's Adjusted ROA was 28% in 2015. This is not only +4x the U.S. average cost of capital, it is also thrice that of the traditional 9% ROA being reported for the firm. By adjusting for the firm's $34.1bn goodwill, the returns ORCL earns from the operational activities of their acquisitions 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.
In addition, by excluding the firm's massive liquidity (excess cash) and keeping just the cash necessary for the firm's operations in our Adjusted ROA calculation, we have a better view of the firm's returns. All in all, ORCL is more profitable than what traditional metrics might suggest. This is an important 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 UAFRS-based Asset Growth) and is the real annual growth rate of the Uniform 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.
From 2007-2011, ORCL experienced strong Adjusted Asset growth ranging from 12% to 37%. During this period, ORCL strategically acquired companies that were about to default on their debt. Note that these were companies poised for profitability and had the potential to beat their competitors. After this period of aggressive growth, ORCL's Asset' growth fell to 2% in 2012, and continues to remain around these levels.
Valuation Relative to Adjusted Assets - V/A'
The third panel shows the Adjusted Value to Assets ratio (V/A'), a UAFRS 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 using UAFRS 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.
The firm's Adjusted ROA of 28% indicates that equity markets may be undervaluing ORCL's equity with a current Adjusted Value to Assets ratio of 3.8x. Moreover, although Valens' Adjusted Value to Assets ratio is higher than the firm's traditional P/B of 3.2x, the difference is not too significant. In addition, given the relationship of the firm's Adjusted ROA and Value to Assets ratio, a 28% Adjusted ROA firm should merit a 4.3x Adjusted Value to Assets ratio. Since Adjusted Value to Assets and traditional P/B are much lower than the warranted valuation, there is potential for equity upside.
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 with UAFRS 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.
Oracle's as-reported Forward P/E is at 13.5x, indicating that their equity is undervalued by the market (considering that long-term P/E ratios average around 15x to 17x). Meanwhile, our analysis finds that ORCL has an approximately 15.4x UAFRS-based Value to Earnings ratio, which indicates that their equity is fairly valued. However, if ORCL decides to again grow aggressively while maintaining superior Adjusted ROA levels, there is potential for equity upside.
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 mismeasurements that result are decision-changing issues.
A far better picture of the economic reality of Oracle Corporation can be seen once those distortions are removed with Uniform Adjusted Financial Reporting Standards. The firm is generating returns roughly three times what most financial databases report and has an Adjusted Value to Assets and an Adjusted Value to Earnings ratio that indicates equity upside potential. With that context of corporate performance and market valuation, we have a far better means for evaluating ORCL's stock price prospects.
Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article. 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.