Performance and Valuation Prime™ Chart
For context, the PVP chart above reflects the real, economic performance and valuation measures of Danaher Corporation (NYSE:DHR) 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, as-reported financial statements and financial ratios of DHR 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 DHR were primarily driven by the inclusion of the firm's immense goodwill ($26.4bn), which inflates the firm's asset base, and by incorrectly expensing R&D ($1.2bn) and operating leases ($261mn) rather than treating them as part of the company's investments.
After adjusting for similar issues and a host of other GAAP-based miscategorizations with UAFRS, Valens calculates DHR's Adjusted Return on Assets as 16% in 2015. In contrast, most financial databases show a traditional ROA of only 5%, which is below cost of capital. Meanwhile, the firm's UAFRS-based Value-to-Earnings ratio is 35.9x, at the peak of historical valuations, while the firm's traditional forward P/E is at 17.8x. The profitability of DHR's operations and their 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 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 to remove the aforementioned GAAP accounting issues and provide consistent analysis.
DHR's Adjusted ROA was 16% in 2015, more than 2x the U.S. average cost of capital and thrice the firm's traditionally reported ROA of 5%. The spread between DHR's Adjusted ROA and its traditional ROA is driven by an understatement in the company's UAFRS-based Earnings from Operations (the numerator, Earnings'), and an overstatement of their UAFRS-based 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. Uniform Adjusted FRS resolve the accounting issues between the expensing and capitalization of certain expenses.
Additionally, adjustments must be made to accurately reflect the economic impact of the Pall acquisition. Traditional accounting does not capture the profitability of the Pall assets that DHR acquired in the period before the acquisition closed, thereby making the Adjusted ROA in 2015 look lower than it actually is. Once these adjustments are made with UAFRS, they indicate that increased profitability related to the transaction effectively offset the impact of operations discontinued in 2015. This left DHR with a cost profile similar to that prior to the acquisition.
Furthermore, by adjusting for the firm's $26.4bn goodwill with UAFRS, the returns earned by DHR through its operations can be identified. This adjustment provides 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.
DHR appears to be more profitable than what traditional metrics might suggest, even considering that their profitability levels have not yet benefited from their most recent acquisitions. 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 UAFRS-based Asset Growth) and is the real annual growth rate of the UAFRS 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.
DHR has maintained strong Adjusted Asset growth over the past decade through numerous acquisitions. They grew their Adjusted Asset base by 35% in 2007, acquiring Tektronix, Inc. for $2.9bn before slowing growth to 3% in 2008. They then continued their strong Adjusted Asset growth in 2009 when they purchased two different healthcare business units worth $1.1bn. Afterwards, Adjusted Asset growth slowed to 6% levels in 2010, ramping to 32% in 2011 after DHR merged with Beckman Coulter and sold Accu-sort to Datalogic.
From 2012-2015 Adjusted Asset growth slowed to 2%-15% levels. Although DHR's Adjusted Asset growth never reached peak levels seen in 2007 and 2011, the firm has continued its acquisitive nature, acquiring Navman Wireless, Nobel Biocare Holding AG, NetScout Systems, and Pall.
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, utilizing UAFRS to adjust 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.
DHR is trading toward the high end of historical valuations relative to asset values with an Adjusted Value to Assets ratio of 4.7x, almost twice the firm's traditional 2.8x P/B. Based on adjusted valuations, the firm appears to be overvalued as an Adjusted Value to Assets ratio of 4.7x would have to be supported by an Adjusted ROA of at least 31%, twice the firm's actual Adjusted ROA.
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.
DHR's as-reported forward P/E is at 17.8x, initially indicating that the firm's equity may be fairly valued (considering that long-term P/E ratios average around 15x-17x). However, our analysis finds that DHR is trading at a historically high 35.9x Adjusted Value to Earnings ratio. Equity downside may be warranted if Adjusted ROA' levels continue to fall, of if the firm fails to realize synergies from their acquisitions.
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 Danaher Corporation can be seen once those distortions are removed by utilizing Uniform Adjusted Financial Reporting Standards. The firm generated returns roughly thrice what most financial databases report in 2015. However, adjusted valuations indicate that the firm's equity is already trading at historically high valuations relative to assets and earnings. With that context of corporate performance and market valuation, we have a far better means for evaluating DHR'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, Rafael Formoso. 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 am/we are short DHR.
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.
Additional disclosure: Officers of Valens Research and Valens Equities are engaged and have beneficial interest in an investment management company, Kennebec River Capital, which has positions in Danaher Corporation (DHR) as of the date of this report.