A few days ago, I had published the 13th edition of the freefincal stock analyser that auto-generates Hewitt Heiserman Jr.'s Earnings Power Box, thanks to the efforts of Rs. Srivatsan, who explained how to identify good business from bad one using it in a guest post: It’s Earnings That Count: Forget the next Infy; Can you identify the next Satyam? This is an update to that sheet after correcting a couple of issues.
The automated stock analyser pulls financials from morningstar, stock price history from moneycontrol and calculates the intrinsic value in six different ways, along with Dupont analysis, Graham number, Piotroski and Altman Z-scores for financial health.
Earnings Power Box
This is a plot of two the Defensive EPS (earnings per share) vs Enterprising EPS
The idea is to spot where a company falls in.
This is based on: Earnings Power Valuation ModelOpens in a new window (doc file).
Srivatsan has defined enterprising and defensive EPS as follows:
Enterprising EPS = (Enterprising Income)/(Shares Outstanding)
Defensive EPS = (Defensive Income)/(Shares Outstanding)
Enterprising Income = Net Income - (15% x total capital)
15% here is the weighted average cost of capital (WACC) and is an expected return. You can modify this for each FY and for each stock.
15% x total capital = enterprising interest.
Defensive Income = Free Cash Flow (thanks to vinamrachaware at Valuepickr for pointing this out. ) He also cautions that
as Operating Cash-flow excludes taxes and interest accrued but not paid
Defensive earning as FCF won't be comparable wrt PAT/EPS
Dear Pattu,
A few thoughts:
1. In the enterprising income calculation, you seem to be applying the 15% (WACC) charge to total capital (i.e. debt + equity). To be fair, you should compare the cost that emerges to the total returns (net profit + interest paid). Alternately, take only the equity capital, apply your 15% charge to it, and compare to the net profit
2. In your tab "Earnings Power Box", can you re-look at the calculation in row #46? I feel that the debt gets overstated here. Because you only need to pull the debt from the your "Analysis" tab, but you seem to be doing some more complex calculation with this
Thank you for putting this together, and for taking time out to build so many sheets, and sharing with people at large. It is indeed a pleasure to see passion in action - in any field.
1. At the core, the approach here is to "charge" a cost (say, 15%) to capital. Then compare this charge to the returns on that capital
2. If the capital in question is defined as total capital (debt + equity) then the 15% charge should be applied to that total capital. This should then be compared to returns on that total capital. Return to debt capital = interest paid (which is the amount that accrues to debt holders). Return to equity capital = net profit (which is the amount that accrues to shareholders). So the total returns here = Net profit + Interest
3. If the capital in question is only equity, then the 15% charge should be applied to equity capital only (book value of equity). This should then be compared to returns that accrue to that form of capital i.e. to net profit
4. Currently, the way you have done it is not apples to apples. You have defined capital as total capital (debt + equity), and applied the 15% charge to this total. But you have compared that with only net profit (which is returns that accrue to only equity capital). So it's a mishmash of two things. To be consistent, you need to follow either the method stated in my point #2 above or the one in point #2
1. Heiserman treats equity capital also as a form of debt collected from shareholders :). This is a major tweak/interpretation / innovative view from Heiserman
His logic is that companies pay interest on their debt alone and quote it as an expense in P&L.
For the combined interest rate on total capital (debt+ equity), he uses the WACC
2. on 15%
- 15% is the risk adjusted return for inheriting the business risks like Crude oil price, Trump H1B, BS3, monsoon, Brexit, demonetization etc. I want my stock to perform "inspite" of these.
3. I request the readers to go through pg 3, 13 of attached pdf (RBSA).
4. For sector specific WACC of Indian companies, I request the readers to download this excel and get the wacc values -
http://www.stern.nyu.edu/~adamodar/pc/datasets/waccIndia.xls
Now, I can't to fully understood the problem here, but as long as there are not problems with the actual computation (there was, now corrected), and it is only a matter of interpretation, then I will leave it to the user to do as fit.
Although the earnings power box can be generated with data from morningstar in under 20 seconds, the tool is only meant for users who spend a lot longer in studying and interpreting the data
Srivatsan will explain more about these assumptions and limitations (everything has them) in a couple of days.
Earnings Power Box Rogues Gallery
I redid the results published earlier. Have updated them there too. Please remember that this tool is not for those who do not understand what the above definitions stand for. Do not take the graphs at face value. Context matter and always evaluate a stock in multiple ways.
Features of the Automated Stock Analyzer
The automated stock analysis sheet
- pulls financials from morningstar and analyses them
- pulls adjusted stock price history from money control, and
- calculates intrinsic value six different ways!
It also pulls annual (standalone/consolidated) and quarterly financials from Value Research online.
Valuation models available:
1) Price Multiple Model
2) Sustainable Growth Rate
3) Book Value Growth Rate (Buffett’s approach to valuation)
4) Discounted Cash Flow(DCF)
5) Reverse DCF Valuation
6) Graham formula and Graham number
7) Piotroski Score for the last 9 financial years
8) Earnings Growth Estimate.
9) Automated Return on Equity Analysis with the Dupont Formula
10) Altman Z-score
Download the freefincal stock analyser V13 with Earnings Power Box
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Dear Pattu,
Thank you for updating this, and for taking the effort to sync up with Srivatsan ji on the point I raised.
I still think the following formula disproportionately penalizes companies which have debt (versus debt free companies), even if that debt is very manageable and enhances shareholder returns:
The formula --> Enterprising Income = Net Income - (15% x total capital)
Take the case of two companies, both with same total capital of 100 cr. Company ZD has no debt, so 100% equity. Company D has 30% debt. Both companies earn 20% on capital. This return on capital is a characteristic of business attractiveness, and not capital structure. Here is how the math will work.
Company ZD:
Capital = 100 cr; of which equity 100 cr
Return on capital = 20 cr (i.e. 20% of total capital)
Interest paid = 0 cr (since zero debt)
Return to equity shareholders (Net profit) = 20 cr (since no interest goes out, all returns flow to equity holders)
Return to equity holders per unit of capital put up = 20 cr / 100 cr of equity = 20%
Company D:
Capital = 100 cr; of which equity is 70 cr and debt is 30 cr
Return on capital = 20 cr (i.e. 20% of total capital)
Interest paid = 3 cr (assuming, say 10% interest on 30 cr of the debt)
Return to equity shareholders (Net profit) = 17 cr (total return on capital minus the interest paid)
Return to equity holders per unit of capital put up = 17 cr / 70 cr of equity = 24.3%
So actually, company D (with debt) is doing a better job in providing returns to shareholders versus company ZD (24.3% versus 20%).
But how does the Enterprising Income formula treat them?
Company ZD:
Enterprising Income = Net Income - (15% x total capital) = 20 cr - (15% x 100 cr) = 5 cr
Company D:
Enterprising Income = Net Income - (15% x total capital) = 17 cr - (15% x 100 cr) = 2 cr
Company D seems less "enterprising" than company ZD, whereas the reverse is true. So the right way to do this would be using the formula:
Enterprising Income = Net Income - (15% x EQUITY capital) = 17 cr - (15% x 70 cr) = 6.5 cr
This reveals that company D is more enterprising than company ZD.
Another way would be to use TOTAL returns (which is Net profit + Interest) in the formula:
Enterprising Income = TOTAL RETURNS - (15% x total capital) = (17 cr of net profit + 3 cr of interest paid) - (15% x 100 cr) = 5 cr
This at least does not penalize company D, and shows that ZD and D are equally enterprising. This is true at a "business level" i.e. they both generate the same return on capital.
The real truth, if you are a shareholder though, is that company D is in fact, more enterprising.
Ok, this is what Srivatsan has to say. Please note I am a neutral party here and I enjoy and welcome any and all intelligent comments.
====
1. I reiterate, the methodology is how Heiserman views capital and returns on it. Is it perfect? May be not. Is it reasonable? Yes. You have already given enough disclaimers in your post about the suitability and usability of the tool.
2. When I compute return on capital, I want to consider ALL the capital of the business (debt, equity and idle cash). That's the whole logic. However, One is free to compute returns on capital as they seem fit taking equity alone.
3. Isn't the point of whole exercise trying to find companies that can "self-fund and create value"? when I mean self-fund, I mean zero debt. Yes, Heiserman will penalise debt-ridden companies. However cheap the lending rate may be.
4. I don't agree with clubbing Interest expense with a Net profit. one is an outgo and another is inflow. They can't be added as "returns"
He also adds that he is a novice and a student of the subject.
Thank you for the update. It is different perspectives that make a market.
Srivatsan would probably pay a higher premium for a debt free company than I would (I would also pay a premium, but clearly not as much as Srivatsan would).
Hopefully, we will all make money!
The one tip I would leave for readers though is to be open about the perspective on interest. Srivatsan feels that interest is an outgo and should not be viewed as returns. I do not subscribe to that view. The reason is this:
Total capital = Equity + Debt. There are thus two types of providers of capital.
The company gets this capital, puts it to use, and generates returns. Each provider of capital gets returns which is called by a different name.
1. Net profit is easy, it is returns / inflow to the shareholders (providers of equity capital).
2. Interest may be viewed as inflow / returns to providers of debt capital. From this perspective, interest is thus not an outflow but an inflow.
As I said, there will always be different perspectives, and that's what makes a market. I just wanted to highlight this perspective, for readers to absorb, and take their own decision.
That's all from my side on this topic!