Performance and Valuation Prime™ Chart
The PVP chart above reflects the real, economic performance and valuation measures of Coty Inc. (NYSE:COTY) 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 COTY do not reflect economic reality. The traditional ROA computation understates the company's profitability by incorrectly including certain items. The distortion of COTY's profitability measures and valuation metrics are primarily driven by the inclusion of the firm's goodwill ($1.5bn) and other intangibles ($1.9bn), which inflate the firm's asset base.
After adjusting for similar issues and a host of other GAAP-based miscategorizations, Valens calculates COTY's Adjusted Return on Assets as 24% in 2015. In contrast, most financial databases show a traditional ROA of only 5%. Additionally, our analysis shows that COTY has an Adjusted Value-to-Assets ratio of 7.0x, compared to the firm's traditional forward P/B at 78.9x. The profitability of COTY'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.
COTY's Adjusted ROA was 24% in 2015. This is not only close to 4x the U.S. average cost of capital, it is also nearly 5x that of the traditional 5% ROA being reported for the firm. The spread between COTY's Adjusted ROA and its traditional ROA is mostly driven by an overstatement of their Adjusted Total Operating Assets (the denominator, Asset').
Additionally, by adjusting for the firm's goodwill ($1.5bn) and other intangibles ($1.9bn), the returns earned by COTY 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. The firm has a 24% organic Adjusted ROA, and a 13% acquisitive Adjusted ROA, much better than the firm's 5% traditional ROA. COTY thus 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 2011-2013, COTY experienced strong 8%-19% Adjusted Asset growth as the company continued its growth in the prestige channel and in emerging markets. In 2013, they accelerated their presence in South Africa and 13 other African countries through a strategic agreement with Indigo Brands Proprietary Limited, a wholly-owned subsidiary of AVI Ltd. Coty secured Indigo and AVI's other subsidiaries as the exclusive manufacturer, distributor, and marketer of Coty's value brands. In the same year, the company entered into a joint venture with Chalhoub Group and Jashanmal, a UAE-based luxury goods distributor, to strengthen Coty's business in the United Arab Emirates.
After this period of strong Adjusted Asset growth, their Adjusted Asset growth slowed down to 2% in 2014 as they focused on repaying their debt, significantly reducing their cash. That said, the company continues to invest in different growth opportunities as they continue to partner with giant brands like CHANEL and Hypermarcas S.A. They also have a pending deal with Procter & Gamble for ten of its fragrance licenses, a deal that could be worth up to $16.0bn.
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.
COTY is trading near the high end of historical valuations relative to asset values with an Adjusted Value to Assets ratio of 7.0x, much lower than the firm's traditional 78.9x P/B. The classic P/B figure is distorted because the traditional calculation utilizes the firm's book value as the denominator, as opposed to the total operating assets of the company. In COTY's case, the $1.4bn worth of shares repurchased by the company in 2015 artificially decreased the firm's book value, leading to the firm's absurd valuations.
However, considering that the firm's ROA' is at 24%, the firm's V/A' of 7.0x indicates that the market may be overvaluing 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.
COTY's as-reported forward P/E is at 25.6x, making their equity appear overvalued by the market. This is supported by our Adjusted Value to Earnings ratio of 24.2x that indicates that COTY is trading toward the high end of historical valuations. Traditional and adjusted valuations indicate that the firm's stock may be somewhat expensive.
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 Coty Inc. can be seen once those distortions are removed. The firm is generating returns roughly five times what most financial databases report. However, traditional and adjusted valuations indicate that COTY's stock price may no longer be cheap. With that context of corporate performance and market valuation, we have a far better means for evaluating COTY'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.
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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.