Long-Term Direction in Corporate Valuation
In our post-Enron investing environment, we may expect to see new trends both in how investing works and in how corporations report their results. Even the structure of the market itself is under review in the spirit of reform and reevaluation.
The New York Stock Exchange, for example, has traditionally been viewed uncritically as the most important trading center in the United States. The lower costs and less formal rules associated with the NASDAQ have put the NYSE under scrutiny. Today, the role of the exchangeand of all exchanges, for that matterhas merged from the relatively simple exchange functions into a combined exchange-and-regulatory function. The exchanges have a duty to regulate member companies, and through listing standards and enforcement of federal and state laws, the exchanges are beginning to take a more active and aggressive role in enacting and enforcing rules.
In this changed market environment, not only are the exchanges undergoing change, but planners and analysts are also taking a new look at the very assumptions used in making important financial decisions. The use of core earnings is perhaps the most significant step in this new trend; but at the same time, older methods are coming under question as well. For example, it was assumed for many years that the calculation of Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) was a valid method for identifying cash-based results for companies. This assumption is questionable, and we now realize that it is very inaccurate.
The most vigorous attempts at placing a fair valuation on a stock investment may be elusive and difficult for even the most skilled analyst. In the past, EBITDA was recognized by many analysts, accountants, and investors as a necessary adjustment to arrive at a reasonable definition of cash-based profit (cash flow versus earnings). The intention under EBITDA was a good one: remove the nonoperational expenses (interest and taxes) and add back the noncash expenses (depreciation and amortization), and the result will be a realistic cash-based, true operating net income number.
The problem, of course, is that EBITDA begins with some flawed assumptions. First of all, there is far more to what is included in "earnings from operations" than as calculated under the EBITDA system. The pro forma income from profit-sharing investments, unexpensed employee stock options, capital gains or losses, reversal or reserves for acquisitions, and other possible core earnings adjustments all have a significant effect on earnings and still pass through the EBITDA formula untouched. Secondly, the adjustments made for amortization and depreciation do not place revenues on a truly cash basis. In any review of working capital, it becomes evident that a massive shift in inventory, accounts receivable, accounts payable, and other current assets or liabilities also have a significant impact on earnings. For example, a change in assumption concerning bad debt reserve or inventory loss reserves may easily alter reported earnings.
Key Point: EBITDA served a useful purpose in the past in some respects. Under the current environment, though, it is of no real value.
Originally developed to enable analysts to review corporate earnings on a like-kind basis, EBITDA is now recognized as a deeply flawed system. The accounting adjustments that are allowed under GAAP make EBITDA less than adequate to create a fair reporting system. For example, in 2002, WorldCom disclosed that it had inflated earnings by $3.8 billion when it capitalized operating expenses rather than writing them off. Under EBITDA, not only would current earnings be inflated, but future amortization would be added back to earnings as well. Thus, the whole adjustment would have disappeared forever.10
We can see how an EBITDA adjustment would change the numbers for the three corporations used previously as examples to demonstrate how drastically the whole picture would change. All of the data in Table 1.3 are from the previously cited Web sites for the companies.
Table 1.3 EBITDA Adjustments, Three Examples
Under the calculation of core earnings, EPS fell in all examples. This is a reliable premise, since net earnings as reported included noncore transactions. Under EBITDA, the earnings picture is inflated. Considering the degree of change for these noncash and nonoperational adjustments, the level of change from reported earnings is enormous. However, it is not realistic to assess a company's earnings pretending that interest, taxes, and depreciation/amortization are not part of the overall equation. The original intent of the EBITDA adjustment, which can be traced back to the 1980s when leveraged buyouts complicated the evaluation of profitability, no longer seems applicable to the fair evaluation of long-term investments. In the 1970s, EBITDA appeared to offer the solution to buyout potential valuation, adjusting all reviewed companies to the same cash-income assumed basis. As long as amortization of big-ticket reserves was included in the buyout, profitability was obscured and distorted. However, EBITDA does not stand up well under today's accounting environment, especially when compared to a more in-depth analysis of core earnings. In today's market, according to Moody's Investors Service in a 2000 report:
...the use of EBITDA has evolved from its position as a valid tool at the extreme bottom of the business cyclewhere it was used to assess low-rated creditsto a new position as an analytical tool for companies still in their halcyon days.11
Closely related to EBITDA is the calculation of pro forma earnings. Pro forma has been defined as "a figure excluding some revenue, expense, gain, or loss that is required to be included in net income under GAAP, or includes some items not permitted or required to be included by GAAP."12
If this definition sounds like a rationale for tinkering with the books, there is good reason. The whole pro forma approach to reporting earnings came under fire shortly after the corporate scandals came to light; like EBITDA, pro forma was abused in many cases. Because there is no precise formula or definition to pro forma, it has served in the past to justify any adjustments corporations wished to makeas long as they explained those adjustments away as pro forma. The report "Pro Forma Earnings: A Critical Perspective" issued by Bear, Stearns supports the use of pro forma, citing the well-known book Security Analysis (Graham & Dodd), the FASB, and even the SEC.13 However, none of their citations specifically endorse pro forma as a method worthy of use. Analysts have been criticized in the past for misusing pro forma results to inflate their buy recommendations.