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.
Invested capital is the accumulation of investments that have been made into a business’ core operations, in order to earn NOPAT. As with NOPAT, I calculate invested capital from both an operating and financing perspective, the results of which should be the same. From a financing perspective,
Invested Capital = Total debt & leases + Equity Equivalents + Common Equity
Invested Capital = Net Working Capital + Total Adjusted Fixed Assets
where,
Net Working Capital = Operating Current Assets – Non Interest-Bearing Current Liabilities
and,
Total Adjusted Fixed Assets = Tangible Assets + Intangible Assets + Other Assets
I make a number of adjustments to strip away the impact of non-recurring and non-core items in order to unearth the true economics of a business. An example of what that looks is given in the tables below, with Diamond Hill as my subject.
Firstly, I calculate Diamond Hill’s invested capital 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 total assets, as shown below:
The virtue of this approach is that it gives me an insight into the true economics of a business while being replicable, scalable and transparent.
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)
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:
Unconsolidated subsidiaries, also referred to as investments in associates, investments in affiliated companies, and equity investments, are businesses wherein a firm has a significant stake that falls short of control, which equates to a 20% to 50% stake, and as such, they come under equity method accounting.
Where the unconsolidated subsidiary’s income is disclosed, I consider that income as operating and add it to my calculation of the parent company’s NOPAT, and invested capital and where it is not, I consider it as non-operating and it does not form part of my calculation of NOPAT, given the figures are undisclosed, and invested capital, and is added to my calculation of economic book value (EBV), just as if it were excess cash.
Firms use a portion of their cash and cash equivalents and investments as operating cash for the running of the business, and any cash beyond this amount is excess cash and a non-operating asset. As a rule of thumb, I assume that operating cash is equal to 5% of revenue, increasing or decreasing this requirement according to the firm’s operating profitability. Excess cash grants firms optionality, and protection against crisis, and, compounds as a consequence of a firm’s profitability.
As excess cash is not needed for operations, it can be distributed to shareholders, and so, I add it to my calculation of economic book value (EBV). In 2023, Meta Platforms had $61.48 billion in excess cash, which I added to my calculation of its EBV.
The logic of discontinued operations is that they are not a component of core operations and therefore, not only do their earnings not belong in a calculation of net operating profit after tax (NOPAT), they also do not belong in a calculation of the invested capital that generates NOPAT. So, I banish them from my calculation of invested capital.
When it comes to estimating economic book value (EBV), one can say that the logic of discontinued operations is that, if businesses are held for sale, the cash earned from that sale is cash that enriches shareholder value. Therefore, it makes sense to add the net assets of discontinued operations to EBV.
Deferred compensation is that portion of employee compensation that has been set aside for future payment. Firms create plans to manage the assets that will be used to settle these liabilities. Consequently, deferred compensation assets are a non-operating liability, which is to say that they are not part of the invested capital that is used to earn net operating profit after tax (NOPAT) for shareholders.
Although deferred compensation agreements create a liability for a business, that business may not match that liability with requisite assets. Deferred compensation assets are netted against deferred compensation liabilities to determine the funded status of the firm’s obligations. Where there is a net asset, that is added to my calculation of economic book value (EBV) and where there is a net liability, that is deducted from my calculation of EBV.
Deferred tax accounts arise because of differences in how firms and the government account for taxes. For example, whereas the government uses accelerated depreciation to calculate taxes owed, firms employ straight-line depreciation. The taxes the company will actually pay, its “cash taxes”, will be lower than the tax expense or provision for income taxes that it will report.
When the business’ reported income is less than its taxable income, the firm generates deferred tax assets (DTAs), whereas when its reported income is greater than its taxable income, deferred tax liabilities (DTLs) are created. They are either reported on the face of the balance sheet, or off its face, hidden away in the notes. DTAs increase a firm’s reported assets, whereas, DTLs can be seen as a kind of interest-free debt.
In my calculation of economic book value (EBV), I deduct DTLs, net of DTAs because they are real obligations that will have to be paid in future, reducing shareholder value. DTAs, net of DTLs, on the other hand, are not added to EBV because they cannot be converted into shareholder value, by selling them, for example, and, because they do not represent real value. The most famous example of net DTLs is Berkshire Hathaway, who, in page K-103 of their 2023 annual report, disclosed net DTLs of $92.34 billion.
As I discussed in “Overfunded Pension Plan Assets, an Invested Capital Adjustment”, under SFAS 158, companies are obliged to report the net funded status of their pensions, which is the difference between the fair value of their pension plan assets and the plans’ projected benefit obligation, i.e. the present value of their future pension obligations. Underfunded plans are, in effect, borrowings from employees and will require repayment at some point in the future and so, the degree of underfunding is deducted from my calculation of economic book value (EBV). Overfunded plans have dead capital that is not required to generate a return to meet projected benefit obligations and so, this is added to my calculation of EBV.
The adjusted total debt of a firm is the sum of the fair value of all its short and long-term obligations, on-balance sheet and off-balance sheet. For example, in 2023, the combination of Meta Platform’s on-balance sheet debt and its operating, variable and not-yet commenced leases, gave it an adjusted total debt of $47 billion, $10 billion greater than the operating lease liabilities, and long-term debt the company reported on its balance sheet. This was due to the impact of its variable and not-yet commenced leases. Without digging into the company’s notes, this would go undetected. I subtract this value from my calculation of economic book value (EBV) to reflect the priority debtholders have over shareholders.
When a company has majority control of a subsidiary but does not own 100 percent, the entire subsidiary must be consolidated on the parent company’s balance sheet. The funding other investors provide for this subsidiary is recognised on the parent company’s balance sheet as non-controlling interests (formerly called minority interest). When valuing non-controlling interests, it is important to realise that the minority interest holder does not have a claim on the company’s assets, but rather a claim on the subsidiary’s assets.
The fair value of non-controlling interest liability is subtracted from shareholder value in my reverse discounted cash flow (DCF) models to reflect the reality that non-controlling interests have claims on cash flows, reducing economic book value (EBV).
