Book Reviews, Value Investing

Book Review of It’s Earnings That Count by Hewitt Heiserman, Jr.

I had this book for a long time and it’s one of those books that I have been wanting to read because the concept sounds good just from the title. The full title of this book is “It’s Earnings That Count: Finding Stocks with Earnings Power for Long-Term Profits” by Hewitt Heiserman, Jr. The book has an accompanying website here.

Good thing is, the book is as good as it sounds. The book is written in a clear, straightforward, reasonably concise manner. For readers who are not that familiar with financial statements, there is a quick introduction to the various financial statements and explanations of key line items and accounting concepts. For more experienced readers, they can skip over the basic stuff quickly to get to the meat.

Essentially, the ‘defensive income statement’ proposed by Hewitt calculates Free Cash Flow, and the ‘enterprising income statement’ calculates Economic Profit. In addition to focusing on the evaluating the quality of earnings, the book also goes into assessing management, competitive advantage, valuation, types of companies to avoid, and a long list of very good ideas on what to do and what not to do when managing your own investments.

I have not captured many of the things in the summary below because they are just too detailed and too many. I always enjoy books that go into details while still being concise and non-repetitive and this book delivers well.

Overall, this is a very good book and I highly recommend people to read this if they are doing fundamental analysis and managing their own investments!

Hewitt identified 4 problems with accrual income statements:

  1. Omission of investment in fixed capital (i.e. capex)
    • Use of cash but not accounted for in the income statement.
  2. Omission of investment in working capital
    • Use of cash but not accounted for in the income statement.
  3. Intangible growth-producing initiatives (e.g. R&D, advertising) are expensed immediately
    • Penalizes companies that invest for higher future sales and earnings.
  4. Earnings reinvested back in the business are not treated as an expense
    • No charge is recorded for the use of shareholder’s equity.

Two types of income statements are then suggested to solve the 4 problems above:

  1. A defensive income statement which addresses problems #1 and #2 by expensing the use of cash each year, and helps to determine whether a company is able to self-fund.
  2. An enterprising income statement which addresses problems #3 and #4 by capitalizing intangibles and amortizing over useful life + expensing an opportunity cost of shareholders’ equity, and helps to determine whether a company is creating value.

Before diving into creating the defensive/enterprising income statements, a 5-minute test is suggested to filter out risky companies:

  1. Auditor’s Opinion: Read the Auditor’s Opinion in the 10-K to make sure that it is a “going concern” and that the financial statements “present fairly, in all material respects, … in conformity with accounting principles generally accepted…”.
  2. Lawsuits: Read footnotes for legal proceedings that can seriously harm the company. Stay away if you don’t understand the full impact of a lawsuit.
  3. Unusual losses: Check how often the company reported unusual losses (e.g. bad debt, inventory write-downs, severance payments to laid-off workers, etc.) in the last several years.
  4. Earnings restatements: Almost every major financial disaster was preceded by an earnings restatement. Make sure the company has not restated in the last several years.
  5. Intangibles assets ratio: [(Goodwill + other intangibles) / Total assets] should be < 20%. Intangibles can be impaired and quickly disappear from the balance sheet. In credit crunch times, intangibles are hard to sell. Large intangibles are also a sign of management overpaying for acquisitions.
  6. Debt-to-equity ratio: [(Sum of all interest-bearing debt including working capital lines of credit, short-term debt, long-term debt, and capital leases) / Shareholders’ equity] should be <= 75%.
  7. Revenue growth: Look for revenue growth of >= 30% over the last 5 years (cumulative, not annual figure). Best revenue growth comes from increase in units sold, followed by price increases.
  8. Stock-based compensation ratio: [Stock-based compensation / accrual profits] <= 15%. This measures how much of the profit goes to employees rather than shareholders.
  9. Short ratio: [Number of shares short / Float] <= 15%. If more than 15%, understand why and determine if that is justified.

Defensive Income Statement

  1. Key concept
    • A company can self-fund if it is producing more cash from ongoing operations than it consumes, even after taking into account its spending for growth (i.e. investments in fixed assets and working capital beyond maintenance needs).
  2. Start off with the standard Accrual Income Statement.
  3. Take a charge for investment in fixed capital
    • Look at capex-to-depreciation ratio to get a sense of the split between maintenance capex and discretionary capex. Maintenance capex should be slightly more than depreciation.
    • Add back depreciation.
    • Subtract all capex, and also the cash cost of any acquisitions (found in Cash Flows from Investments) because they are a use of cash, and the benefits are uncertain.
  4. Take a charge for investment in working capital
    • Working capital assets include accounts receivable, inventory, prepaid insurance premiums, other current assets, etc.
    • Working capital liabilities include payables, accrued expenses, dividends payable, income taxes payable, and other current non-interest-bearing liabilities.
    • Subtract the change in Net Working Capital (working capital assets – working capital liabilities)
    • Rapid growth in receivables relative to growth in payables means trouble. Reasons include:
      • Management giving generous payment terms to persuade customers not to switch to a competitor
      • Poor collection efforts
      • Customers unable to pay their bills
      • Customers unwilling to pay due to unresolved issues
    • Large increases in inventory may be good (accumulation for a holiday shopping season, or accumulation for a new product launch), or bad (production outpacing sales, inventory obsolescence, high storage costs)
  5. Subtract any non-operating sources of cash, e.g. tax benefit from stock-based compensation, investment income, interest income, etc. These are not coming from operations and may not be present in future periods.
  6. Subtract the increase/(decrease) in net deferred tax assets (i.e. deferred tax assets – deferred tax liabilities). My note: An increase in deferred tax liability means the income tax provision in the income statement is higher than the required cash tax by an amount equal to the increase in deferred tax liability. This amount is non-cash at that period, hence should be reversed. Similarly, an increase in deferred tax asset means the income tax provision is lower than the required cash tax by an amount equal to the increase in deferred tax asset. In accrual accounting, this amount has been “pre-paid” hence it is an asset. However, this is a true cash charge, hence the amount should be subtracted.
  7. Defensive Taxes is defined as Accrual Taxes (i.e. the provision for taxes) + the investment in net deferred tax assets. Defensive Taxes replace the Accrual Taxes in the Defensive Income Statement.
  8. If defensive profits (i.e. after incorporating the above adjustments) are high compared to last 5 years, be wary of management milking the business
    • Compare with capex-to-depreciation ratio, and working capital trends (growth in working capital, working capital as % of revenue) of companies in the same industry.

Enterprising Income Statement

  1. Equity is more expensive than debt because
    • If as an equity holder, you assume greater risk than debt holders, you need a larger payoff.
    • Debt is cheaper because it is a deductible expense
    • There is an opportunity cost because the money can be invested in other businesses or instruments.
  2. Capitalizing intangibles
    • Capitalize R&D and advertising spending from operating expenses to capital assets. Reverse out the expensed R&D/advertising spending, and only expense the amount depreciated for the 1st year. The amount expensed should also include the “depreciation” for the R&D/advertising spending in the previous years (that has not yet been fully “depreciated”).
    • Rules of thumb for depreciation period (aka useful life)
      • Fortune 500-type, profitable companies with positive net worth: 10 years for R&D, 5 years for Advertising
      • Start-up-type, unprofitable companies with negative net worth: 3 years for R&D, 2 years for Advertising
    • Can create a gross expense for R&D/Advertising, less accumulated depreciation, to obtain Net capitalized intangibles, just like fixed assets.
  3. Subtract any non-operating sources of cash, e.g. tax benefit from stock-based compensation, investment income, interest income, etc. These are not coming from operations and may not be present in future periods
  4. Take a charge for using stockholders’ equity
    • Net Enterprising Capital (aka Invested capital) =
      • + Debt (working capital line of credit + current portion of long-term debt + long-term debt + other senior liabilities)
      • + Stockholders’ equity
      • + Deferred tax liability
      • + Net capitalized intangibles (explained above. note that this was not previously on the balance sheet, so it actually results in both an asset and an equity item)
      • + Capitalized operating leases (remember to reverse the imputed rent expense, read below)
      • – Excess Cash (for a large established company, usually any amount exceeding 2% of revenue)
      • – Short-term investments
      • – Marketable securities
    • As the Net Enterprising Capital changes throughout a year, take the average of the beginning and ending of the year figures.
    • Estimate the WACC
      • Pre-tax cost of debt = interest expense / average debt balance
      • Ibbotson Associates estimates the cost of equity for S&P 500-type companies as approximately 13-15%.
    • Enterprising Interest = Net Enterprising Capital * WACC
    • Subtract the Enterprising Interest from the Income Statement as an interest expense on using stockholders’ equity.
    • The Enterprising Interest contains interest on the capitalized operating leases. Since the income statement already includes lease expense, the interest on the capitalized operating leases need to be added back to the Income Statement else there will be double counting and the company will be unfairly penalized.
    • To calculate Enterprising Taxes (i.e. taxes in the Enterprising Income Statement):
      • Start with Defensive Taxes (i.e. taxes in the Defensive Income Statement)
      • Add the Interest Tax Benefit from any accrual interest expense (i.e. we are reversing out the tax shield benefit by increasing the taxes). This is equals to interest expense * marginal tax rate.
      • Add the Interest Tax Benefit from the implied interest expense on operating leases. Make an assumption on the discount rate (e.g. 8%). Capitalize the operating leases. Take the average of the capitalized lease value over 2 years. Using the same discount rate acting as the interest rate, obtain the implied interest expense by multiplying it with the average capitalized value. The tax benefit is equals to the interest expense * marginal tax rate.
      • Add the Intangibles Tax Benefit. This is equals to the difference between the accrual expense for intangibles and the new “depreciation” expense for intangibles, multiplied by the marginal tax rate (e.g. if previous accrual expense for new advertising is $10, and the revised “depreciation” expense for intangibles is $8, we need to reverse the tax benefit for the $2 difference).
      • Subtract the original tax on non-operating income. For any non-operating income that was on Accrual Income Statement, as the income would be removed from the Enterprising Income Statement, the tax on that income should be removed (i.e. reduce the tax by the non-operating income * marginal tax rate).
    • Quick check: Pre-tax Return on Capital = EBIT / (Total Debt + Stockholders’ Equity) > 18% means the company probably has enterprising profits.

Quality of Profits and Earnings Power Charts

  1. Quality of Profits Chart
    • For each year, show the accrual profits, defensive profits, and enterprising profits as 3 vertical bars.
    • Plot the results of the 3 bars across multiple years in a single chart.
    • Plot the stock price as of each of the financial year-ends. To ensure the stock price incorporates the results of that year, use the stock price that is 30 days after the company filed its 10-K.
    • Look for trends, and explanations for any sharp differences among the 3 types of profits.
  2. Earnings Power Chart
    • Plot each year’s Defensive Profits and Enterprising Profits on a scatter plot (x-axis is Enterprising Profits, y-axis is Defensive Profits).
    • Lower-left box: Unable to self-fund and create value, e.g. Enron
    • Upper-left box: Able to self-fund but destroying value, e.g. WorldCom
    • Lower-right box: Creating value but not able to self-fund, e.g. Lucent
    • Upper-right box: Have authentic earnings power – they are able to self-fund and create value, e.g. Wrigleys
    • Great companies keep on moving in an upper-right direction each year. Two years (“steps”) of operating history in that upper-right direction qualifies as an Earnings Power Staircase. Buy such companies when they are young.
    • A turnaround candidate may reside in the other quadrants. Signs of a turnaround candidate
      • New products/services introduced
      • Improved production efficiencies
      • Increased sales
      • Growing backlog of new orders
      • Improved working capital management
      • Debt is reduced
    • Earnings Power Chart is not suitable for banks because of their highly leveraged capital structure, or natural resource companies because of their sensitivity to commodity prices.

Earnings Power Ratios

  1. Debt Repayment Period
    • D/E ratios are not as good because
      • Companies don’t repay debt by selling assets unless they are really in trouble.
      • Banks look at ability to service debt through cash flows, not at the shareholder’s equity cushion.
      • Book value of equity includes fixed assets which is likely overvalued on the balance sheet.
    • Debt Repayment Period = Debt & Equivalents / Normalized Defensive Profits. It should be <= 5 years.
    • Debt includes working capital lines of credit, current portion of long-term debt, long-term debt, and capital leases. Debt equivalents are capitalized operating leases.
    • Normalized defensive profits = Average of last 4 years worth of defensive profits.
  2. Return on Greenest Dollar
    • Measures the return made on the latest investment in capital. Tells you whether management is allocating capital intelligently.
    • Return on Greenest Dollar = Change in Enterprising NOPAT / Change in Enterprising Capital
    • Enterprising NOPAT = Enterprising Profit + Enterprising Interest
    • Good companies have Return on Greenest Dollar from high teens to 200+%.

Measuring Management

  1. Look for the following:
    • Executives owning stock
    • CEO being candid in annual reports and conference calls
    • CEO’s resume and good track record
    • Reasonable executive compensation
    • Independent board of directors
    • Few related-party transactions
    • Reasonable fees to auditor to maintain independence
    • Few acquisitions because they are hard to get right
    • Sparing use of debt
    • Diluted shares outstanding not increasing at a high rate
    • Dividends being paid only when defensive profits are growing and not when company is making defensive losses (dividend / defensive profits should be <= 50%)
    • High employee morale, infrequent reorganizations / restructuring, no history of strikes, etc.

Competitive Advantage

  1. Ask yourself: What makes this company special? How long will it remain unique?


  1. Decide the total return that you want
  2. Total return = Dividend yield + Capital appreciation
  3. Calculate the Enterprise Value today
  4. Calculate the Enterprise Value 10 years out, that is needed to achieve your required Capital appreciation
  5. Estimate the P/E ratio at the end of 10 years.
  6. Back out the required Earnings 10 years later.
  7. Calculate the required CAGR of earnings.
  8. Compare that required CAGR with the historical earnings CAGR to determine if the required CAGR is reasonable.
  9. If not reasonable, put in watch list.

Heiserman gives a long list of ideas to become a better investor. Three are particularly interesting to me:

  1. Formulate an investment strategy, write it down. Specify the criteria of companies you look for, holding period, buying and selling rules, etc.
  2. Learn from your mistakes. There is a quote from Jim Cramer, “almost all of my good moves in the market are made because I have made so many bad ones — but took exquisite notes on the bad ones so they never happened again.”
  3. Take care of yourself. Get regular exercise, be positive. Research shows that optimists live ~20% longer than pessimists. Money has a low correlation with happiness once basic needs are met.

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