Performance and Valuation Prime Chart
The PVP chart above reflects the real, economic performance and valuation measures of Expedia, Inc. (NASDAQ:EXPE) 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, as-reported financial statements and financial ratios of EXPE 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 EXPE were primarily driven by the inclusion of the firm's immense goodwill ($10.8bn) and other intangibles ($3.3bn), which inflate the firm's asset base, and by incorrectly expensing R&D ($830mn) and operating leases ($109mn) rather than treating them as part of the company's investments.
After adjusting for similar issues and a host of other GAAP-based miscategorizations, Valens calculates EXPE's Adjusted Return on Assets as 17% in 2015. In contrast, most financial databases show a traditional ROA of only 2%, far below the cost of capital. Meanwhile, the firm's Forward Adjusted Value-to-Earnings ratio is 14.6x, at the middle of historical valuations, while the firm's traditional forward P/E is at 20.5x. The profitability of EXPE'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 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.
EXPE's Adjusted ROA was 17% in 2015, more than 2x the U.S. average cost of capital and more than 8x the firm's traditionally reported ROA of 2%. The spread between EXPE'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.
Furthermore, by adjusting for the firm's goodwill of $10.8bn and their other intangibles worth $3.3bn, the returns earned by EXPE 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.
With everything considered, EXPE appears to be far 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.
EXPE has maintained strong Adjusted Asset growth over the past decade through numerous acquisitions. They grew their Adjusted Asset base by 15% in 2007 before ramping growth to 28% in 2008 due to their acquisition of Venere.com. Adjusted Asset growth then slowed to 3% in 2009 before once again ramping to 21% when the firm acquired Mobiata. This strong Adjusted Asset growth continued, reaching 22% in 2011 and 16% in 2012 with their acquisition of VIA Travel. The firm's Adjusted Assets then slowed to 0% levels, ramping once again to 19% in 2014 and 16% in 2015 due to the firm's acquisitions of trivago GmbH, Wotif, Travelocity, Orbitz, and HomeAway.
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.
EXPE is trading at the middle of historical valuations relative to asset values with an Adjusted Value to Assets ratio of 4.1x, almost twice the firm's traditional 2.8x P/B. Based on adjusted valuations, the firm initially appears to be overvalued by the markets as an Adjusted Value to Assets ratio of 4.1x would have to be supported by an Adjusted ROA of at least 27%, almost twice the firm's actual Adjusted ROA. That said, the firm's equity may be fairly valued relative to assets if analyst expectations are realized.
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.
EXPE's as-reported forward P/E is at 20.5x, initially making the firm's equity appear overvalued (considering that long-term P/E ratios average around 15x-17x). However, our analysis finds that EXPE is trading at the middle of historical valuations with a 14.6x Adjusted Value to Earnings ratio. Therefore, there may be equity upside if Adjusted ROA' levels rise from normal 16%-19% levels seen in the last five years, as analysts project.
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 Expedia, Inc. can be seen once those distortions are removed. The firm generated returns more than 8x what most financial databases report in 2015. Moreover, adjusted valuations indicate that the firm is trading at only modest levels relative to earnings. With that context of corporate performance and market valuation, we have a far better means for evaluating EXPE'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, Cheska Pablico. 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.