What is true earnings?

If you look at a financial results, sometimes you can see different earnings being reported. We can also derive our interpretation of earnings based on cash flow or other parameters. What do all these earnings mean and which is the true earnings for the year?

As earnings and earnings growth are important components in the DCF calculation, it is important to ensure we consider this carefully. I will start by defining all the earnings and I will use Haw Par FY2017 financial results as a case study.

A) GAAP earnings - this is the straight forward and I think most people will use this. The reported net income or profit taken directly from the income statement. For Haw Par, it is $125.5m or $0.57/share.

B) Comprehensive income - this includes other non-operation items, eg currency translation difference, fair value changes of financial assets etc. This is also reported in the income statement. For Haw Par it is $793.6m or $3.60/share.

C) Free cash flow - this is simply calculated as Cash Flows from from operating activities less Capital Expenditures (Purchases of property, plant and equipment). It is $106.8m - $8m = $98.8m or $0.45/share

D) Owner earnings - Buffett defined this as Reported earnings + Depreciation and Amortisation + changes in working capital - Capital expenditure. It will be $125.5m + $3.5m + (-$5.8m + $1.6m+ $4.6m) - $8m = $121.4m or $0.55/share

E) Look through earnings - the concept is that all corporate profits benefit shareholders regardless they are paid out as dividends or as retained earnings. In brief, this is the company own reported GAAP earnings plus the share of undistributed earnings of the financial assets, which are not reported in the company P&L under the conventional accounting. For Haw Par, the undistributed retained earnings from UOB & UOL comes up to $153m. If I add this to the pre-tax profit of $140.8m and apply the same tax rate of 10.9%, I will get look through earnings of $261.8m or $1.20/share

F) Underlying earnings - this will be the earnings generated from the core business. It excludes one-off charges, any extraordinary event or highly irregular financial transactions which might false inflate the earnings, eg profit from sales of a subsidiary business. For Haw Par, there seems to be no one-off charges, so in this case, the underlying and GAAP earnings are the same.

G) There could be combinations of the above, eg using underlying earnings instead of GAAP earnings in calculating the Owner earnings or FCF or Look Through earnings.

There could be some errors in my calculation above, so don’t take it as absolute. The intent is not to accurately calculate all the earnings but to show the different earnings we can get.

Can see that it ranges, on per share basis, from $0.45 to $3.60 for Haw Par case. This is a quite a huge different and will surely affect the intrinsic value calculation and also the ratio like PE, ROE, ROA, ROIC.

Like to hear from value investors on what is your approach in determine the true earnings of a company. I have my approach, which I can share later.

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traderx

analogy: same as investors who said made good dividends but shares price (their initial capital) dropped till cannot recognise own house, so actually is in red.

allenlow

i use comprehensive income attributable to owner to check. even loss in forex reserve still must consider mah.

allenlow

Reply to @ThumbTackInvestor : still must consider mah sometimes, but must "adjust" it accordingly. or some companies got invest in listed securities, and got unrealized loss (this Q strats trading got 20mil unrealized loss...). forex loss wont really affect my decision, but some other loss must take into account ((:

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Snorlax

Ok. There is two questions for this.

1) How you obtain the $x/share in term of number ?
2) for (E) right, where do you obtain "For Haw Par, the undistributed retained earnings from UOB & UOL comes up to $153m." ?

TIA

theintelligentinvestor

Reply to @Snorlax : 1) Total HP shares is 220.2m, so just divide whatever earnings by this to per share basis.

2) From UOB and UOL annual reports.

UOB retained earnings in 2017 was $19,707m and in 2016 was $17,333m. So the increased for the FY2017 was $2,373m. HP owns 73.2m shares of UOB total shares of 1,661.3m, or 4.41%. So HP share of the retained earnings was $104m.

Same calculation done for UOL, I will have $89m as retained earnings.

Total retained earnings = $193m.

I think I took a 20% off that to come up with $154m. The 20% was sort of being conservative, I can’t rem exactly. But this was just an example and i just want to show the example of how look-through.

bgting

There is yet another way to work out earnings, more useful for longer term. That is the change in NAV over the years, adjusted for distributions.

For A), I believe last year's earnings for many US companies are not useful, related to the tax changes.

marginofsafety

Reply to @bgting : "I wonder why his reading of Graham and Dodd is different from mine."

LOL. I felt the same way as well. I think he based his criticism off the later editions of SA, which is ridiculous imo cos as far as I know those editions have tons of collaborations and doesn't even reflect the thinking of Graham as much as the first couple editions.

Credits to him for coming up with the concept of resource conversion and a new definition of current assets etc though. Real smart guy but his books (with the exception of Dear Fellow Shareholders) felt impossible to get through though :/

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theintelligentinvestor

Thanks to all for your comments, appreciate it.

I think option A), C) and F) are popular choices with some mentioned on E) look through earnings.

To share own my view as I have promised. I used all except (A).

My base is to start with C) FCF, D) Owner earning and F) underlying earnings. C) removes the non cash depreciation and add in the real capital expenses and F) takes care of non-recurring earnings. I would also use average of 3 or sometimes 5 years average as more realistic earnings power of a business.

Actually I realised I did a mistake in the definition of owner earning. Buffett defined the capex to be the necessary to maintain the company's current level of sales, ie the maintaining capex. So the Capex if can be split into two, ie 1) Capex for maintaining and 2) Capex for growth, but it is difficult to determine and most people will take the total Capex to be conservative. Also the change of working capital offers some flexible to select which changes you want to put back, eg you may not want to include changes in inventories or receivables for a growing business.

Depending on the business, eg insurance with float or companies with large amount of investible assets, I would use E) look through if the earnings information of the investment is available or B) Comprehensive income if it is just reported as unrealised gain.

marginofsafety

Reply to @theintelligentinvestor : Re: Owner earnings

Go to the Berkshire meeting transcripts, CTRL-F " Compulsory reinvestment and “owner earnings” ".

"In the case of the businesses that we’re in, both wholly owned and major investee companies, we regard the reported earnings — with the exception of the — some major purchase accounting adjustment, which will usually be an amortization of intangibles item — we regard the reported earnings — actually the reported earnings plus — plus or minus, but usually plus — purchase accounting adjustments, to be a pretty good representation of the real earnings of the business."

PS: To make things easier, just use OCF - depreciation. Greenblatt talks about using depreciation as a proxy for maintenance capex in his class notes. I think you couldn't go much wrong with that if you just want a rough estimate.

Simpleinvestorsg

For look through earnings, I do consider if the retained earnings from these investments provides sufficient value for their retention. Buffett usually invest in stocks that are efficient in the use of their capital. whether through buy backs or dividends, or he has some way to influence how those companies utilizes capital. I prefer simple company structures unless the CEO has been proven himself to be an excellent capital allocator.

theintelligentinvestor

Reply to @Simpleinvestorsg : Agree with your view.

A big plus point is when the retained earnings for investment is generating higher return on these additional capital.

Thanks for sharing, your comments are always insightful!

sadisticnoob

avoid companies with many "one-off" and other income. If profit goes up , net operating cash flow should go up in tandem as well .

theintelligentinvestor

Reply to @sadisticnoob : Yes, I always looked out for too many one-off, eg companies slowing selling assets to gain income than from their core operation.

As for CFO growing in step with profits, I observed that it may not happen within a year or short term due to changes in working capital. But over a long term, I agree that it is a red flag if they are not in tandem.

LFO

I look for recurring income and stability of income. Those one-off items will be removed.

If revenue is up but net profit is down, then will drill into the reason/(s) for cost increase.

Free CF is also important. Best if cash flow from operations demonstrates growth YoY.

theintelligentinvestor

Reply to @Look : Thanks for your insights on Wilmar and Genting.

I agree on the retrospective view and sometimes unexpected behaviour of the market on stock prices.

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wellhandy

I'm definitely not a value investor. (in stricter definition of the term.)

Most of the time, I only look at A.
If I get more interested, I have a look at C.

theintelligentinvestor

Reply to @wellhandy : Thanks for your feedback.

Actually I think most will select A, C & F.

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