Geoff Gannon June 1, 2011

Asset-Earnings Equivalence

Someone who reads the blog sent me this email:

When it comes to valuing a business, do you believe more in asset valuations or earning? Earnings aren’t guaranteed to be there in the future (depending on the industry, of course), but assets are only worth what you can sell them to somebody else for. Do you think a pizza shop should be analyzed based on how much pizza they sell or the value of its real estate & bank account? Should they all be assessed when determining a value for the business? This is the question i’ve been thinking about in trying to understand valuation…

I think earnings and asset valuation are kind of the same, because operating (earning) assets generate earnings. So the value of those earning assets are the present value of future expected earnings (owners’ earnings) generated by those assets…Then I think we need to add things like real estate, cash, marketable securities which i think are non-earning or non-operating (core) assets, then subtract liabilities to arrive at value of the firm as a whole.

Assets and earnings are equivalent.

You can always restate an asset in terms of earnings. And you can always restate earnings in terms of an asset.

You can always ask: what would this asset have to earn to be worth what the balance sheet says it’s worth? And you can always ask what someone would pay for a certain amount of earnings. If they’d pay that amount that means they’d trade you cash today for those earnings. And that means earnings can be thought of as being worth their (cash) sale value. So earnings can always be thought of as if they were an asset.

In physics, mass is a measure of the energy content of a body.

In investing, value is a measure of the earning content of a specific instance of capital.

When I say a business will provide earnings of 40 cents a share pre-tax and a business is worth $4.00 a share – I’m really saying the same thing under special conditions (certain interest rates).

Intrinsic value is always relative.

You can’t value anything without a reference point.

There are two ways you can value an asset. You can value it in static terms by comparing it to other assets and valuing the asset against them. This uses other assets as your reference point. Or you can value an asset by restating it as a flow of earnings and comparing that flow to the price-to-free cash flow multiples of other businesses. This uses other cash flows as your reference point.

Really, you’re just valuing the same thing – capital – in two different states.

This is very obvious if you look at businesses over time. Or if you look at special situations. Or deals of any kind.

Basically, capital starts its life in a business with no earnings and a lot of potential. Then it gets put into all sorts of specific forms (real estate, inventory, receivables, intangibles). These forms produce cash flows which throw off earnings that again build up as assets of some kind.

The process is constantly cycling.

Understanding this idea of asset-earnings equivalence will help you avoid errors caused by a one track mind.

Take the example of a business that has $4.75 in cash per share and 40 cents in pre-tax earnings per share. Let’s say the stock trades for $4 a share. Sounds fair, right?

After all, that’s a P/E of 15 after-tax. Hardly cheap.

Here’s the problem with that logic.

Let’s say businesses can be bought and sold for 10 times pre-tax earnings in our little investing universe. At first – from an earnings perspective – it seems fair for a stock with 40 cents in pre-tax earnings to trade for $4.

But then we remember that assets and earnings are equivalent. Obviously, if businesses really can be bought and sold for 10 times pre-tax earnings, the company we’re looking at can just use its $4.75 in cash and buy another 47.5 cents of pre-tax earnings by going out and acquiring another business. But then the stock would have 87.5 cents of pre-tax earnings, which would make the stock worth $8.75 a share. Not $4.

Again, we’re just saying the same thing two ways. An asset worth $4.75 plus 40 cents of pre-tax earnings equals $8.75 a share (if 10 times pre-tax earnings is a common multiple at the moment).

Capital on the balance sheet is just potential earnings on some future income statement.

But – and this is where we get into the softer side of the science of investing – capital doesn’t move as freely from each of its special forms.

Cash can turn into earnings very easily because it can be converted into any other form of capital instantly.

What about land? What about inventory? What about machinery?

It depends.

Some of these assets are stuck capital. Machinery is often such a special and rigid form of capital that it’s economically equivalent to a prepaid expense.

I pay my website hosting fees ahead of time and my website stays up for another month. It’s a prepaid expense. The only value I get out of this asset is the use I put the website to over the next 30 days.

Likewise, machinery may be carried on the balance sheet at its original cost less accumulated depreciation – but it’s really just worth however much use you can get out of it.

That’s not true of cash.

And it’s not true of assets like inventory and receivables if – and only if – they can be turned into cash and removed from the business under certain circumstances.

Often, when sales decline, inventory and receivables can be turned into cash and put to use in new lines of business.

That’s part of the genius of Ben Graham.

He focused on current assets. Under many – but not all circumstances – current assets that are underperforming in terms of earning production can be turned into other forms of capital that will earn the returns generally available in the economy.

You can apply this test to any stock you buy for its assets. Just pick a rate of return – I suggest using the 30-year AAA corporate bond yield – and apply it to the tangible invested assets of the stock you’re looking at.

Remember to separate invested assets from assets that have accumulated on the balance sheet – like cash – that aren’t being used in the business. Then apply the long-term rate on safe business bonds (today it’s 5%) to the invested capital inside the business.

So, take a business with $12 of invested tangible book value and multiply that $12 per share times 5% to get 60 cents in pre-tax earnings potential. That gives you some idea of what the business’s capital could produce in earnings if put to use someplace else.

Why does the earning potential of capital matter if the capital isn’t earning up to that potential now?

Two big parts of net-net investing are return of capital and transformation of capital. Return of capital means turning more and more assets into cash and kicking them back to shareholders. Transformation of capital means investing the same old capital in new and different ways.

So how should you value a business? Should you use earnings or assets?

I don’t look very hard at a stock’s earnings unless I think there’s something special about the kind of capital in the business.

Take FICO.

Each of those four letters F-I-C-O are probably worth between $100 million and $150 million. In other words, the FICO name is worth $400 million to $600 million easy.

Intangible assets are often carried on balance sheets at amounts that have nothing to do with their economic value. So when I look at a business like FICO, I look at the earnings. They give you a clearer idea of the value of the intangible assets the company controls.

The same would be true of a movie library. It’s often easier to look at the cash the library throws off than the amount the library is carried on the books at.

Talk to Geoff about Asset-Earnings Equivalence