Quality of Earning : Financial latticework to trace Multibaggers Part-2

As a student of investing, in my early days back between 2010 to 2014, I like many others wondered why a certain company's reported earning was valued at say Rs.10 and another's at Rs.50. I had a gut feeling if I could understand this clearly, I would have unraveled a mystery that would help me think clearly & take better investment decisions. I let the question linger in my head and read through Berkshire Hathaway Letters to Shareholders , The Warren Buffett Way , Poor Charlie's Almanack , Common Stocks Uncommon Profits , The Intelligent Investor , Security Analysis , Buffett: The Making of an American Capitalist , Buffettology , Warren Buffett and The Interpretation of Financial Statements and many other books on investing written by outlier practitioners & observers. I applied all I learned in analyzing businesses as a research analyst subsequently. I got an intuitive idea about the mystery I was trying to unravel, but still couldn't wrap my head around it with a level of clarity, I would be comfortable with.

It was when I started a family business as the managing partner from scratch and got it up running & profitable over a span of a year and a half, that it started making concrete sense as I saw the line items of the financial statements and the economics of the business that I had learned in theory & observed in businesses as a research analyst, now in active motion in the real business world as a businessman. Condensing my experience that I had already connected to the theory and observations while reading businesses, I developed a framework to think of the quality of earning. This article discusses the same in detail.

A lot of focus in evaluating a business is given to earnings per share. Based on which an investor decides how much are they willing to pay for each rupee of earning and that brings us to a widely used valuation metric Price to Earning ratio. However, little attention is given to the quality of the earning and a quick judgement is passed, if an investor finds it attractive, the lower the price to earning ratio the better is the investment opportunity. That brings us to the crucial question, Can the quality of earning be measured?

I think yes, one can make an educated guess with some smart effort. Let's see how,

There are two aspects to the quality of earning: 1.Current 2. Prospective

Current Quality of Earning

The Current quality of earning can simply be defined as the percentage of reported EPS is actually there in cash terms. To simplify we will consider Net Income, which when divided by no of outstanding shares equals EPS. So, effectively the percentage of Net Income that is generated in cash terms is the current quality of earning. Owners earning is the equivalent of Net Income in cash terms. So, the actual measure is Owner's earning/ Net Income

Owner's earning = Net income (adjusted for non recurring items) + Non cash items - Maintenance invested capital

Maintenance invested capital = Maintenance working capital + Maintenance CAPEX

Maintenance invested capital is the capital that the company needs to invest to keep its position in its industry. By that I mean to maintain its Profit share & Profitability (as measured by Return on Invested Capital) in the industry. Since profit share is difficult to compute we use the proxy of Market share and make sure the profit margins of the company remains intact. Any investment above this quantum of maintenance invested capital is for growth of Profit share (Market share).

Since computing the Maintenance invested capital requires a through understanding of the business, FCFF/Net Income serves as a decent proxy in most cases, except for those that are investing heavily to increase their market share and effectively profit share.

Computing Maintenance invested capital is a topic that deserves exclusive attention to be understood thoroughly and hence we will leave that for another article for a later point in time.

Prospective Quality of Earning

The prospective quality of earning is the certainty with which you think the future earnings with growth can flow to the business owners. Its about how certainly will you be able to capture the future value that you create. This is a bit subjective and does not have a straightforward equation like the current quality of earning.

Prospective quality of earnings depends on the following:

Management quality-Management's Rationality, Candidness in communication & Ability to resist the herd mentality.

Product nature-B2B or B2C, Need or Want, Secular or Cyclical, Demand vs Supply of the Product sold, Recurring demand or one of purchase, Buying behavior- Mind share or Value added or Lowest price.

Business structure-Porter's 5 forces, Types of moats.

Once you get a hang of the above idea by personally applying it across businesses, you would appreciate, why a certain company's reported earning is valued at 50 and another at 10 and would improve your clarity of thought and quality of your investing decisions. I will be attempting to connect the quantitative parts of my first article to the qualitative parts of this article in my next article. Stay tuned!

Note: This article is a sequel to, Financial latticework to trace Multibaggers - Part-1