Annual reports are not merely long, and complex, with often abstruse language that seems calculated to befuddle the reader, they are also structured in ways that unintentionally disguise operating performance. To start with, financial statements are not designed to be particularly helpful for an investor seeking to understand the operating performance and value of a business. This is because they mix together core and ancillary business activities and transitory shocks. Income statements commingle operating income with interest expense and other non-core, non-recurring items; balance sheets mush together operating assets, non-operating assets and sources of financing; and cash flow statements blend operating cash flow with investing and financing cash flow.
An added difficulty is that the elements we need to determine the operating performance of a business are not simply on the face of the financial statement, but they are sprinkled across the annual report, in the MD&A, the footnotes and notes. Moreover, managers are given enormous discretion in classifying items and how they can present disclosures. Further complications are that judgement must be exercised to determine a disclosure’s impact on operating performance and to place each disclosure in the proper economic category.
Therefore, in order to analyse the operating performance of a business, a rather mundane and yet very important task must be undertaken: the operating, non-operating and sources of financing items of each financial statement must be properly classified, not only on the face of these financial statements, but in the MD&A, the footnotes and notes. In doing so, I make a series of adjustments to convert the income, and balance sheets into net operating profit after tax (NOPAT), invested capital and free cash flow (FCF) statements that reveal the true economics of a business.
In their wonderful paper, “Core Earnings: New data and Evidence”, researchers Ethan Rouen, Eric C. So, and Charles C.Y. Wang, present an accurate, rigorous, replicable, and transparent way to estimate core earnings. Their paper is based on an analysis of the remarkable work by financial research firm, New Constructs, who use artificial intelligence and human analysts, to analyse thousands of 10-Ks, and classifies all earnings related quantitative disclosures into their appropriate economic category. At the time the paper was published, New Constructs analysed 60,000 10-Ks, between 1998 and 2017. One of the great achievements of this remarkable paper is that it presents an accurate, rigorous, replicable, and transparent approach to estimating core earnings, while also showing that there is enormous alpha to be gained from having an accurate measure of core earnings. It is that methodology that I use.
In order to get a sense of the recurring and repeatable profitability of the core business, I calculate its NOPAT. NOPAT excludes income from ancillary business activities and transitory shocks, is independent of a company’s capital structure, and is available not just to shareholders, as with GAAP net income, but to all capital providers. NOPAT must be defined in a way that is consistent with one’s definition of invested capital, so that NOPAT is entirely earned from invested capital.
This approach uses the same economic categories detailed in New Constructs’ work and Rouen, So and Wang’s paper, with input from that great textbook, Valuation, by Tim Koller et al. A great deal of judgement is involved in placing all the quantitative items into the correct economic adjustment category, as well as the patience to go through an entire annual report, to find both hidden and reported items. By “hidden” is meant those items that are off the face of the income statement, either because they are located in the MD&A or footnotes, or commingled within a reported item; whereas, by “reported” is meant those items that are on the face of the income statement.
I calculate NOPAT from both an operating and financing perspective, which are mathematically equivalent. From a financing perspective,
| GAAP Net Income |
| + Adj. for Capitalized Expenses |
| + Increase in Equity Equivalents |
| – Other Income |
| + Other Expenses |
| – Hidden Items |
| + Interest Expense After Taxes |
| = NOPAT |
Whereas, from an operating perspective,
| Operating Revenue |
| – Operating Expenses |
| – Hidden Items |
| = Earnings Before Interest and Taxes (EBIT) |
| + Goodwill Amortization |
| = Earnings Before Interest, Taxes and Amortisation (EBITA) |
| + Adj. for Capitalized Expenses |
| + Income Equivalents |
| = Net Operating Profit Before Tax (NOPBT) |
| – Cash Operating Taxes |
| = NOPAT |
An example of the fruits of this procedure is given below, where I first estimate Diamond Hill’s NOPAT from an operating perspective, for the years 2019 to the last twelve months (LTM), ending 2Q 2024:
This can be reconciled with the firm's GAAP net income, as shown below: