You Can Never Be Sure How Fabricated Income and Earnings Are These Days

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Today’s Daily Reckoning has some serious work to do. So put your serious face on. We have our serious brain on. Afterwards, we’ll get unserious. But first…

A Bloomberg headline this morning reads that, “Japan, Australia stock futures slide on valuation concern, oil.” The story then points out that Honda Motors is trading at 107 times net income, which is kind of expensive.

The trouble with using the income statement as a source for valuations is that you can never be sure how fabricated income and earnings are these days. There are all sorts of ‘adjustments to income’ that affect the final number. Plus you have different of income (operating income, interest income, ‘other’ income) that don’t always give you a very reliable picture of just how well a business is travelling and how cheap or expensive the business is relative to its earnings power.

For that, we recommend you go to the balance sheet to look at assets. But be warned! Not all assets are created equal. There are current assets. There are tangible assets. And there are “other assets.” What you really want to find out is how much a business can earn from its net tangible assets without increasing its borrowing or spending (capital efficiency).

Let’s take two examples today. First, Google. From its consolidated balance sheet for the June quarter, you can see that the company finished with nearly $12 billion in cash and ‘cash equivalents.’ That left it with current assets – those it could liquidate to meet short-term liabilities – of $23 billion. Not bad, right?

It might not be too bad. You can see that Google actually has $35 billion in assets. About 34% of those are non-current, and include property, plant, equipment, goodwill and intangible assets. But in the non-consolidated view of assets of current assets, you get a better picture of just how liquid the company’s assets are, and how ‘quality’ they are. Take a look…

Google socked about $400 million into U.S. government agency securities in the quarter. It increased its time deposits and its money market mutual fund holdings. You can also see it reduced its holdings of municipal securities but increased its corporate debt holdings. Altogether, marketable securities make up just under 40% of its ‘cash and cash equivalent’ assets.

So what? Well, as we said, not all assets are equal. Google has to do something with its cash. Why not return it to shareholders? In the notes to its financial statements, the company said its operating costs and capital spending needs are relatively low. So why park so much cash into money market funds and debt securities and U.S. government agency securities?

We’re just speculating now. But we reckon Google keeps a handy cash and near-cash war-chest on hand because it achieves earnings growth through acquisition. And you need cash to acquire other companies. You never know when you’re going to need it, mind you. But it’s good to have it around. This has been Microsoft’s strategy for quite a while.

As an investor, you want management to maximise the returns on your capital, or return your capital. If you’re confident that Google’s management can turn its cash position into future earnings growth (and a higher stock price), you might be happy the status quo.

The only caveat we’d add is that Google has a lot of its assets tied up in securities. Those look like pretty safe and liquid securities. But in the last year, we saw big falls in U.S. government securities. And remember that even a money market fund or two got into serious trouble at the height of the crisis.

The point? As Kris Sayce pointed out in his latest recommendation at the Australian Small Cap Investigator, you can often find good value by looking for a company that’s selling below, near, or slightly above net current assets. It means you get the whole business for around liquidation value of its most liquid assets.

Of course that assumes those assets could be sold at face value. In a liquidation – when you’re forced to sell – you don’t usually get the best price. Think ‘fire sale prices. But shares selling at or near net current assets are definitely worth a look. Tomorrow, we’ll drill down one step deeper and look at net tangible assets and a resource company whose main asset is a big nickel mine. How do you value that? More tomorrow.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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5 Comments on "You Can Never Be Sure How Fabricated Income and Earnings Are These Days"

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Pete
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Tricky times for value investors… if you can’t be sure that the numbers are right, how do you determine value?

Coffee Addict
Guest
To survive the market these days a value investor needs to morph into a rogue trader every now and then. For my own part I’ve concentrated some funds into a blast, drill and truck tray outfit (BDL) on my speculation that their order book was filling up fast. The SP was dead on the back of an atrocious financial year that took them to the verge of bankruptcy. The PE ratio was I recall below 2. The price then took off and I have not idea where it may go next. It doesn’t matter which blast & drill outfits will… Read more »
Ross
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CA, I have done well with WDS on the same basis but on my residual watchlist there aren’t many opportunities within 30% of my target prices now. I use nta, cash, p/e and debt-equity layered on sectoral interest and the individual’s track records. I am watching CXG which fits but you might call it a long bow from your interests, but even though there are too many related party issues for mine they now have Dale Elphinstone invested and I have had respect for his old underground mining business. All these are longs however and I am actually looking mostly… Read more »
Michael
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It is mete that the fabrication of earnings and the elasticity of balance sheet perceptions should be in the same document where Ross mentions CXG. I bought CXG when I learned (i think in 2007) that revenue had jumped, and when I looked at the balance sheet and noticed that Cash and Debtors outstanding added together looked good, I assumed the company was liquid enough. It transpired that revenue was inflated by a huge multi-million dollar sale a few days before the end of the fiscal year to an entity, Greentrains, that had no money, and its ABN had only… Read more »
Dan
Guest

There are a few ways to know whether to trust earnings figures. At least I’ve heard of some, but they aren’t very PC. ;)

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