Thursday, June 23, 2011

Earnings Power When Assets Change

As demand fluctuates, companies with variable costs can scale up or scale down their operations as neccessary. Companies with fixed-costs, however, have tougher decisions to make. While they can cut costs by disposing assets in the face of waning demand, this ends up reducing capacity, which can bite them later. Over the course of this recession, many companies with high fixed costs that have earned tremendous profits over the last several years have had to dispose of assets at fire-sale prices in order to better align expenses with revenues. For the investor assessing whether a company's stock price trades at a discount to its intrinsic value, how is he to determine a company's earnings power in the face of such asset impairments and plant shutdowns?

For companies in stable industries, we have advocated employing Ben Graham's approach to determining a company's earnings power. While this approach of using a company's average earnings over a representative period is appropriate when the level of assets has not changed substantially, it may not be as useful at a time like this when companies are disposing of significant amounts of fixed assets.

Using the company's current earnings is also not an appropriate measure of a company's future earnings power. Current earnings are riddled with red ink due to current charges for labour reduction programs, asset impairments, and revenue drops that outpaced cost reductions.

While not perfect, a better method to estimating a company's future earnings power when assets have been impaired is by examining the company's record of return on assets. Provided the company is in an industry where technological advances are slow and where prices are stable, there will be, at the very least, a loose relationship between a company's earnings and its assets. By averaging a company's past return on assets over a representative period, and then applying this return to the company's current level of assets, the investor can get a better idea of the company's earnings power than if he estimated earnings power by simply extrapolating the company's current earnings, which are influenced by temporary effects.

The importance of limiting the application of this procedure to companies with price stability can not be stressed enough. For companies in commodity industries with volatile pricing, past returns are not neccessarily reflective of future earnings, and therefore the accuracy of this method reduces to the point where its usefulness is rather limited.

However, even if applied appropriately, it is important to note that this method of calculating a company's earnings power is by no means an exact science. Earnings will rarely be exactly proportional to a company's level of assets. However, for companies in slow-changing industries where price levels remain stable, an examination of the relationship between earnings and assets should assist the investor in making a more informed decision about the earnings power of a company under examination as a potential investment.

For a more advanced exercise, investors considering an investment in a capital intensive business may also try replacing return on assets with return on fixed assets, using a budget worksheet.

4 comments:

Richard Beddard said...

I agree, and have said much the same thing ( http://blog.iii.co.uk/a-better-long-term-pe/ ).

But I'm curious to hear you say average past profitability should not be used for cyclical companies. It might be less predictive if a company is cyclical, but surely it still has some value. More than say average earnings, or one year's earnings?

Saj Karsan said...

Hi Richard,

I agree that past profitability is more useful than average earnings and one-year earnings. Where did I write that it should not be used? I will correct it if it is unclear.

Richard Beddard said...

Hi Saj, its just your emphasis on only applying the technique to stable industries. To take the argument to the extreme if earnings are perfectly stable there's no need to average them, or compute average earnings from past profitability. So, while cyclical industries are less predictable I think using average profitability is most useful in these cases.

Saj Karsan said...

Hi Richard,

I agree with you in general, but with the caveats discussed in the article. If a company has sold off assets, it cannot earn its average profits of the past. Also, if it sells commodities with very long cycles, it's very difficult to say that average earnings are that relevant.

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