How to make sense of company reports

When you strip out the padding, company performance – and investing – is all about cash. Paraphrasing an old Warren Buffett line, “the end result is to end up with more cash than you started with, and that’s both at a company level and at the level of the investor,” says Leithner & Company joint managing director Chris Leithner.

But accurately gauging how much cash a listed company really has, and how much it will have in the coming years, isn’t so simple. For one thing, there’s plenty of subjectivity in company results, despite all the financial regulatory requirements, compulsory reporting periods (one of which is about to kick off), and professional accounting standards. With that in mind, two professional investors Leithner & Company's joint managing director Chris Leithner and ECP Asset Management’s Jared Pohl, explain how they make sense of company results.

3 go-to metrics in company results

Leithner names three things he looks at before anything else:

• Operating cash flow
• Sources of cash over the last year and longer intervals
• Operating cash flow versus CAPEX and dividends.

“I pay considerable attention to operating cash flow and comparatively little to net profit after tax,” Leithner says.

“OCF is harder to manipulate than NPAT and is, therefore, less prone to ‘one-off’ adjustments. And most importantly, a company that can’t consistently generate cash from operations is a company whose destiny lies in others’ hands.”

On the second point, Leithner wants to know how important cash from company operations is to its ongoing maintenance and expansion activities. The key question he’s seeking to answer here is how reliant the company is on shareholders and/or lenders.

Test your assumptions

When asked to name three go-to metrics, ECP Asset Management’s Pohl is more circumspect in his response. And again, it comes back to subjectivity, because it depends on your investment thesis.

“The data you assess should be much more idiosyncratic and should be related to the opportunity in question,” Pohl says.

“Specifically, you should be looking for the data in the release that either validates or makes you question the key assumptions upon which your investment thesis is based.”

As an example, he discusses his team’s thought process ahead of its purchase of Afterpay (ASX: APT) shares a few years ago. They saw plenty of room for growth of APT’s Australian customer base and the average spend per customer as the adoption of buy-now-pay-later services increased. International expansion didn’t even come into the equation earlier on.

“But it provided optionality. The investment thesis was built on the growth of and improvement in the following assumptions: Customers, Average Spend per Customer and Net Transaction Margin.

And fortunately for ECP and those other investors who bought in early, APT kept knocking those projections out of the park.

“In 2018, we forecast a processing volume of$9 billion by 2021 (up from $2.2 billion); APT delivered $9.4 billion,” says Pohl.

“At the same time, we conservatively estimated $3.3 billion in processing volumes in the US by 2021; the company delivered $9.6 billion.

Pohl says there are no shortcuts to help investors consistently find such opportunities. “But be clear about the assumptions that your investment thesis is built on, and ensuring that you find data to test the validity of your assumptions will put you in the best position to achieve the best outcome possible.

Be careful not to allow your thesis to drift as the company starts to talk to other opportunities, this would need to be reassessed individually.”

How useful is EBITDA?

“While this is useful when making cross-sectional comparisons, using it in isolation is very likely to be misleading and requires you to do a bit more work," Pohl says.

Again, subjectivity rears its head, which is why we’re increasingly seeing other letters added onto the list of exclusions. (I’ve even seen EBITDAC – earnings before interest, taxes, depreciation, amortisation and coronavirus – mentioned, and not always tongue-in-cheek.)

“This metric seems to always be growing as management try to best position their companies in the eyes of shareholders, by attempting to account for what they believe are nuances in their business model that may be different from others,” Pohl says.

“But this requires them to make a judgement call. Sometimes it's warranted, and in other cases it’s not. You should always question why management makes these adjustments and whether they make sense to you.”

As an example, he points to US camera and social media company Snap Inc, which uses EBITDAS in its investor presentations.

“Snap’s management believes that stripping out stock-based compensation shows the true operating performance of the business. But in 2020, the company reported revenue of US$2.5 billion and a positive EBITDAS of US$45 million,” Pohl says.

“In the same year, it incurred stock-based compensation expenses of US$770 million and associated payroll tax expenses of US$50 million.”

The real kicker comes when you include these expenses, which shows the company delivered an operating loss of US$775 million for the year. That’s why these metrics can be so misleading.

As Pohl explains, the argument that there is no ‘cash’ cost associated with stock-based compensation, so it should be excluded, is partially true.’

“But there is a cost, through share dilution and in-kind payments made to staff,” he says.
“If they weren’t able to provide the stock-based compensation to their staff - would they be able to retain them? Would the business actually be able to operate?”

What are the “red flag” metrics?

Though Leithner stops short of describing it as deliberately misleading, NPAT is the figure he singles out.

“Even honest and competent people can produce different estimates of revenue and expenses, so their estimates of NPAT can vary greatly,” he says.
“Even if there was no “spin” or a slant – however unrealistic that might be – we can’t get past the crux of subjectivity. That’s not a criticism, it’s just reality. There’s always going to be times in which people honestly and competently disagree on things.”

While he concedes it’s not actually a metric, Leithner’s second red flag revolves around complexity and “multiple significant anomalies”.

“If you know a given industry and understand the accounts of Firm A and B, but Firm C’s raises all kinds of questions, then that’s a red flag. And if a company’s accounts are straightforward but its numbers seem too good to be true, then they probably are.”

Use PE ratios with caution

Pohl pinpoints one of the financial industry’s most widely-used metrics, the price-to-earnings ratio, as the most misleading. Why? Because of all the embedded assumptions that need to be understood before the number makes sense.

“Generally, higher PEs are said to be expensive, and lower PEs are said to be cheap. It is generally assumed that a low PE will normalise at a higher level, and a higher PE will normalise to a lower level; hence the adage, buy low sell high,” he says.

A higher expected growth rate for a company, or lower earnings today, may mean a PE is higher than that of another company.

“But that may be justified and may continue for years to come. We’ve seen this often in new software business models that have been running P&L losses as they invest heavily to gain market share and drive scale.

“One stock that we own that falls into this category is Xero Ltd (ASX: XRO), its current forward PE is circa 130 times based on Bloomberg Consensus estimates (as of 10 January).”

Pohl and his team consider large accruals – revenues earned or expenses incurred, which affect a company’s net income – to be significant red flags.

“Investors tend to fixate on headline earnings, but they can forget that earnings are actually a combination of cash-flow and accruals,” he says.

“Higher proportions of accruals would require you to have less confidence in the earnings that are presented by management, and at the very minimum, would require you to do some further digging.”

Numbers don't lie (or do they?)

Subjectivity is everywhere. We all have opinions and they often vary widely. This is a point that arose repeatedly during the above discussions.

“Accounting is not physics – and that’s not a criticism of accountants. The definition and the measurement of revenue has a subjective element, as there is to the timing of costs,” Leithner says.

“Show me two honest, competent and skilled accountants and they’ll come up with significantly different estimates of net profit after tax, and that’s before putting in the “spin” component that companies put on top in trying to present their results in the best possible light.”

It’s a similar point Pohl alludes to in his earlier response, where he suggests it's futile to nominate a few go-to financial metrics. Instead, he emphasises the importance of testing your assumptions. Of course, that also means you need to have these assumptions – or an investing plan – to begin with. 

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Click here to read part one of this collection, where our fundies name a couple of stocks with rock-solid balance sheets.

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