Performance and Valuation Prime™ Chart
For context, the PVP chart above reflects the real, economic performance and valuation measures of Lockheed Martin Corporation (NYSE:LMT) 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 Uniform Adjusted Financial Reporting Standards, 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 LMT 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 LMT are primarily driven by the inclusion of the firm's goodwill ($13.6bn), which inflates the firm's asset base, and by incorrectly expensing R&D ($839mn) and operating leases ($256mn) 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 LMT's UAFRS-based Return on Assets as 16% in 2015. In contrast, most financial databases show a traditional ROA of only 8%. Additionally, our analysis shows that LMT has an UAFRS-based P/E of 23.6x, compared to the firm's traditional forward P/E at 16.6x. The profitability of LMT'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 utilizes UAFRS, which "clean up" the aforementioned GAAP accounting issues to provide consistent analysis.
Lockheed Martin's Adjusted ROA was 16% in 2015. This is not only +2x the U.S. average cost of capital, it is also twice that of the traditional 8% ROA being reported for the firm. The spread between LMT'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 ($839mn) and operating leases ($256mn) 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 $13.6bn with UAFRS, the returns earned by LMT 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, LMT 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 UAFRS-based Asset Growth) and is the real annual growth rate of the cleaned-up 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 the Adjusted ROA, the growth rate explains a lot about management's intended strategies and even performance incentives.
LMT's Adjusted Asset growth has been volatile over the last decade. After their Adjusted Assets shrunk by 1% in 2007, growth ramped to 17% in 2008. Their Adjusted Asset growth then slowed to 2% in 2009 before shrinking by 3% in 2010 following the divestiture of Pacific Architects and Engineers and a majority of their Enterprise Integration Group.
LMT's Adjusted Asset base then grew by 4% in 2011 and 3% in 2012, before once again shrinking by 2% in 2013 and 7% in 2014 due to decreased operating lease investment, as well as a decrease in cash following their acquisition of Systems Made Simple, Zeta Associates, and Industrial Defender (tech companies that mostly contributed goodwill and other intangibles). Finally, their Adjusted Asset base grew 11% in 2015 with their $9.0bn acquisition of Sikorsky Aircraft from United Technologies Corporation.
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, and less excess cash (or non-operating cash balances). Meanwhile, 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. The Adjusted Asset level is the same as the denominator of the Adjusted Return on Assets calculation and the Adjusted Asset growth panel.
LMT is trading at the peak of historical valuations relative to asset values with an Adjusted Value to Assets ratio of 3.7x, though much lower than the firm's traditional 22.2x P/B. The classic P/B figure is distorted because the traditional calculation utilizes the firm's book equity value as the denominator, as opposed to the total operating assets of the company. In the case of LMT, the traditional P/B multiple appears higher than it should be because of the firm's significant accumulated other comprehensive income, which artificially shrinks their equity base. By looking instead at the company's entire asset base, as opposed to the book equity value, which can be distorted by the way management chooses to account for underfunded pensions, Valens is able to get a clearer picture of real valuations.
However, even though traditional metrics are overstating the firm's valuation relative to assets, this does not imply that LMT is cheap. Considering that the firm's Adjusted ROA of 16% warrants a V/A' closer to 2.5x, the firm's V/A' of 3.7x 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.
LMT's as-reported forward P/E is at 16.6x, making their equity appear fairly valued (or even slightly undervalued) by the market. However, our analysis finds that LMT is trading at the peak of historical valuations with an Adjusted Value to Earnings ratio of 23.6x. Considering that LMT is already trading toward the high end of historical valuations, their 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 Lockheed Martin Corporation can be seen once those distortions are removed with Uniform Adjusted Financial Reporting Standards. The firm is generating returns two times what most financial databases report. However, adjusted valuations indicate that LMT's stock price may not be as cheap as traditional valuations indicate. With that context of corporate performance and market valuation, we have a far better means for evaluating LMT'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, Rafael Formoso. 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.