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Measuring Earnings

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Accounting Versus Financial Balance Sheet
• Accounting versus financial balance sheet
• Key issue – Adjusting earnings

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Adjusting Reported Earnings
1. Updating earnings
2. Correcting earnings misclassification due to the following:
 Capital expenses treated as operating expenses (adjustment for R&D)
 Financial expenses treated as operating expenses (adjustment for Operating
leases)
3. Adjustments for
 Extraordinary, recurring and unusual items
 Adjusting for acquisition and divestures
 Income from investment

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Updating Earnings
• Earnings from current annual report
• Obtain as updated an estimate as possible given how much firms
change over time
• Importance of updating earnings
– Younger companies growing at a fast rate
– Volatile companies
– Companies undergoing restructuring so changing substantially

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Updating Earnings
Valuation done in Annual June 2018 June 2017 Updated
August 2018 March 2018 Numbers

Revenue 65225 29100 14500


Operating Income 18385 3332 1250
R&D 1782 824 128
Net Income 14013 6452 2182

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Adjustment for
Capital Expenses treated as Operating Expenses
• Difference between capital expenditure and revenue expense
• Expenses to be adjusted – R & D Adjustment (Most important),
Advertising expenses & Training expenses (can also be considered)
• Applicable in sectors – Pharmaceutical, Software, Consulting, FMCG etc.

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R&D Expenses:
Operating Expenses or Capital Expense
• Accounting rule – R&D should be an operating expense even though it is
designed to generate future growth due to uncertainly of benefits
• For valuation – Treat it as capital expenditures

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Example for Adjustment for R&D
Amgen is a bio technology firm. Suppose FDA norms take 10 years for drug
approval process. The current operating earnings of the firm are Rs.5594
mm and book value of capital is 21985 mm. Given are the R&D
expenditures for the past ten years, what will be the amortization charges
and what will be the value of research asset?
R&D Adjustment
Year R&D expenditure
Current 3030
-1 3266
-2 3366
-3 2314
-4 2028
-5 1655
-6 1117
-7 864
-8 845
-9 823
-10 663
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R&D Adjustment
Year R&D expenditure Unamortized Portion (Amount) Amortization this Year
Current 3030 100% 3030.00 0.00
-1 3266 90% 2939.40 326.60
-2 3366 80% 2692.80 336.60
-3 2314 70% 1619.80 231.40
-4 2028 60% 1216.80 202.80
-5 1655 50% 827.50 165.50
-6 1117 40% 446.80 111.70
-7 864 30% 259.20 86.40
-8 845 20% 169.00 84.50
-9 823 10% 82.30 82.30
-10 663 0% 0.00 66.30
Value of Research Assets = 13283.60
Amortization of research asset this year = 1694.10 10
Converting Operating Expense to Capital Expense

Adjusted operating income =


Operating income + R&D expenses – Amortization of research asset
5594 + 3030 – 1694 = 6930

Adjusted book value of capital =


Book value of capital + Value of research asset
21985 + 13283 = 35268

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You are analyzing the earnings/cash flows of a consulting firm that reported Rs.10
million in operating income this year on a invested capital of Rs.30 million, yielding a
return on invested capital of 33.33%.

In computing these earnings, though, the firm subtracted out Rs. 10 million in recruiting
and training expenses spent during the course of the year on new consultants. Typically,
consultants hired by the firm stay with the firm approximately 4 years, and the
recruiting and training expenses for the last 4 years are as follows:

Year Expense
-1 8
-2 6
-3 4
-4 2

If you capitalized recruiting and training expenses, estimate the correct return on
invested capital for the firm.
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Converting Operating Expense to Capital Expense

• Steps to capitalize R&D


– Specify an amortizable life for R&D expenses – How long does it take for R&D to be
converted on an average into commercial product
– Most crucial, requires judgment, usually 2-10 years; amortizable life for Pharma
companies vs. Software companies
– Collect past R&D expenses for as long as the amortizable life
– Calculate amortization expense and value of research asset
– Adjust the earnings and investment

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Possible Applicability of Adjustment
• Advertising expense/ brand building expenses – Consumer product
companies
• Recruiting and Training expense – Consulting firms

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REMEMBER
• For an operating expense to be capitalized, there should be substantial
evidence that the benefits from the expense accrue over multiple
periods.

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Adjustment for
Financial Expense treated as Operating Expense
• Financial expense – Any commitment that is tax deductible that you
have to meet no matter what your operating results are  Failure to
meet it leads to loss of control of the business.

• Expense to be adjusted – Operating Leases

• Applicable in sectors – Retail stores, Restaurants etc.

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Converting Operating Expenses to Financial Expenses

• Accounting rule – Operating leases expenses as operating expenses


• For valuation – Treat them as financing expenses
• Reclassify them
• Has no effect on equity earnings but does change the operating
earnings

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Operating Lease to Financing Expense
GAP has hundreds of stores that are leased, with the lease being treated as operating
leases. For 2010, GAP has operating income of $1968 and has operating leases as $1129.
The following details provide the lease commitment in the future years taken from
financial statements:
Year Commitment
1 $997
2 $841
3 $710
4 $602
5 $483
6 and beyond $1483

For GAP, the pre-tax cost of debt is 5.5%. How will the operating income be adjusted?
What will be the debt of the company? 18
Operating Income Adjustment
• Average of 5 years lease = 727
• 1483/727 = 2.04 ≈ 2 years
• 1483/2 = 741.50
• PV of lease commitments = 4208.28  Debt = Asset = 4208
• Depreciation on asset = 4208/7 = 601
• Adjusted operating income = 1968 + 1129 – 601 = 2496

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Converting Operating Expenses to Financial Expenses
• Debt Value of Operating Leases = Present value of Operating Lease Commitments at
the pre-tax cost of debt
• Adjusted Debt = Debt + Present value of leased commitments  When you convert
operating leases into debt, an asset is created of exactly the same value.
• Depreciation (SLM) = Value of leased asset/Leased life
• Adjusted Operating income
Operating income + Operating Lease Expenses in current year – Depreciation on
Leased Asset
– As an approximation (only), this can also be considered:
Adjusted Operating income = Operating income + Pre-tax cost of Debt * PV of
Operating Leases.
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Adjustments to Income for Projections

• Be cautious about using current year’s earnings as a base for


projections.
• Adjustments related to:
– Extraordinary, recurring and unusual items
– Adjusting for acquisition and divestures

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Extraordinary, Recurring and Unusual Items
• Operating income that is used as a base for projection should reflect continuing
operations and should not include any items that are one-time or
extraordinary.

• Items:
– One time expense or income
– Expenses or income that do not occur every year but seem to recur at regular
intervals
– Expenses and items that recur every year but with considerable volatility

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Extraordinary, Recurring and Unusual Items
• One time expense or income: Legal expenses, large restructuring cash charges –
Exclude them
• Expenses or income that do not occur every year but seem to recur at regular
intervals: Regular restructuring cash expenses – Average them
• Expenses and items that recur every year but with considerable volatility –
Average them

To access these items, you should have access to financial history of the company.
For a young company long history is not available, use personal judgment is needed.

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Adjusting for Acquisition and Divestiture
• Byproduct of acquisition – Goodwill impairment
• Take the earnings prior to the goodwill impairment

• When a firm divest assets, they generate income in the form of capital
gains:
– Infrequent divestitures – Ignore income
– Regular divestitures – Ignore income but consider in capital expenditure

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Income from Investments
• Investment in marketable securities generate two types of income:
– Interest or dividend
– Capital gains or losses associated with selling securities at a price different form
the cost

• Neither type of income should be considered part of earnings for used


in valuation

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Income from Investments
• Interest earned on marketable securities should be ignored when
valuing the firm Add the market value of these securities at the end
of the process

• Taking capital gain in your income means  Assuming that every time
you will be able to sell your investment at a capital gain which is not a
realistic assumption

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