Performance and Valuation Prime Chart
The PVP chart above reflects the real, economic performance and valuation measures of Oracle Corporation (NYSE:ORCL) 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 ORCL 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 ORCL are primarily driven by the inclusion of the firm's immense goodwill ($34.1b), which inflates the firm's asset base, and by incorrectly expensing R&D ($6.4b) and operating leases ($290m) 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 ORCL's adjusted return on assets as 28% in 2015. In contrast, most financial databases show a traditional ROA of only 9%. Additionally, our analysis shows that ORCL has an adjusted forward P/E of 17.1x, compared to the firm's traditional forward P/E at 14.6x. The profitability of ORCL's operations and its 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.
Oracle's adjusted ROA was 28% in 2015. This is not only +4x the U.S. average cost of capital, it is also +3x that of the traditional 9% ROA being reported for the firm. The spread between ORCL'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 its adjusted total operating assets (the denominator, Asset').
Earnings are understated because the traditional calculation of net income does not recognize R&D expenses ($6.4b) and operating leases ($290m) 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 $34.1b, the returns earned by ORCL 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, ORCL 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 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.
From 2007-2011, ORCL experienced strong adjusted asset growth of 9% to 37%. During this period, ORCL strategically acquired companies that were about to default on their debt - Hyperion Corporation ($3.3b) and Agile Software Corporation ($495m), BEA Systems ($8.5b) in 2008, Sun Microsystems ($7.4b), Art Technology Group ($1.0b), and Phase Forward ($685m) in 2010, and RightNow Technologies ($1.5b) and Endeca ($1.1b) in 2011. 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 slowed down 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 "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 cash 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.
ORCL is trading at the low end of historical valuations relative to asset values with an adjusted value to assets ratio of 4.3x, just slightly higher than the firm's traditional 3.7x P/B. The classic P/B figure is distorted because the traditional calculation recognizes all of the firm's cash as a part of its total assets. The problem with doing this is that assets that are not part of the firm's core operations essentially pad the total assets of the firm in the P/B calculation. In the case of ORCL, the traditional P/B multiple appears lower than it should be because of ORCL's immense excess cash levels.
Moreover, considering that the firm's adjusted ROA is at 28%, the firm's V/A' of 4.3x indicates that the market is fairly valuing the firm's equity relative to its assets.
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.
ORCL's as-reported forward P/E is at 14.6x, making its equity appear fairly valued (or even slightly undervalued) by the market. However, our analysis finds that ORCL is trading toward the high end of historical valuations with an adjusted value to earnings ratio of 17.1x. Considering that ORCL is already trading toward the high end of historical valuations, its stock may not be as cheap as markets perceive.
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 Oracle Corporation can be seen once those distortions are removed. The firm is generating returns roughly three times what most financial databases report. However, adjusted valuations indicate that ORCL's stock price may not be as cheap as what traditional valuations indicate. 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 along with the lead analyst, Caroline Cervillon. 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.