Next to Normalized

Investment analysts are trained to (try to) understand the drivers of the economic performance of the companies they follow, and to translate that understanding into a view on the valuation of those companies’ securities (i.e., stocks, bonds, and the like).  In theory, this is a pretty straightforward exercise.  A company’s securities represent claims of varying priority on its assets, which correspond in turn to claims on the expected future cash flows derived from those assets.  The challenge in practice, of course, is that forecasting the future is difficult; and even if such forecasts were perfectly predictable and widely known (i.e., so that the market had no disagreement about what they are) the market can be fickle in how it prices future cash flows at any given time.

Readers familiar with very basic concepts in corporate finance can probably skip this, as I won’t really get to My Point until the next post.  I think this will be helpful background for the rest of the audience, however.

Imagine two companies, A and B, that are absolutely identical except that they exist in parallel universes.  Imagine them as exceptionally unglamorous companies: say, manufacturers of dental floss.  Assume that, year in and year out, they generate about the same amount of annual free cash flow: this is a term of art, which essentially means the amount of cash earnings that are available to distribute to company’s creditors and equity owners, and to pay taxes, after setting aside an appropriate amount of those earnings to reinvest in the business (for example, to replace depreciating equipment) in order to continue generating that same level of cash earnings (the term of art would be “maintenance capital expenditures,” which we’ll also assume is about the same each year).

We would expect A and B to have virtually identical valuations in the market, since their assets produce identical levels of free cash flow and are expected to do so indefinitely.  If the companies borrow money, clearly some of that valuation would represent claims of their creditors on the free cash flow of the companies.  But, in general, we wouldn’t think of A and B as having fundamentally different values as enterprises just because A and B have different amounts of debt; the salient difference would be what proportion of that value is attributable to creditors and equity owners in each case.

Imagine that the fates of A and B diverge as you are reading this.

In A’s universe, there is a surge in demand for dental floss as the result of an unusually troublesome corn harvest that experts warn, as summer grilling season approaches, is much more likely to become stuck in your teeth.  Such corn harvests are once-in-a-blue-moon phenomena, thanks to advances in modern agricultural science.  But we have every reason to believe, when the books are tallied for the year, that A will have doubled its free cash flow relative to 2010.

In B’s universe, happily, we also expect B to double its free cash flow in 2011 relative to 2010.  But, in this universe, the surge in demand for dental floss is due to a nationwide oral hygiene panic!!  We’ve finally gotten religion about flossing.  Prominent dentists make the rounds on cable news and morning talk shows, warning of newly-discovered dangers of gum disease.  (Impotence! Death!)  Congress declares War on Plaque and appropriates $50 billion of Federal funds to fight it.  Professional-class parents compete for status through the quality of their children’s gums.  (Harvard is watching!)  And when hip-hop stars rap about flossing, they really mean it.

Each company will report the same free cash flow for 2011.  But should the market still ascribe the same value to each enterprise?  Our intuition is clearly no.  Company A seems to have experienced a nice windfall, but we don’t expect that its ability to generate cash flow has changed meaningfully.  It should more or less go back to the same predictable performance it has always delivered.  Put another way, it’s hard to imagine the market will be expecting a once-in-a-blue-moon corn harvest every year.  On the other hand, Company B seems to be riding a major structural change in demand for floss.  In the short run, it may well max out the capacity of its factories.  In the medium-to-long run, it may consider investing in new factories, going to market with different products, consolidating with other operators – all while potentially fending off competition from new entrants.  The Company is clearly on a different trajectory in terms of its likely ability to generate free cash flow in the future, even if we’re not sure what exactly it will be.

This example illustrates why investment analysts attempt to distinguish between recurring and non-recurring drivers of companies’ financial performance.  Related dichotomies in the jargon would be normalized versus reported earnings, and earnings excluding extraordinary items versus including them.  These drivers may play out in a particular quarter or, as in my example, fiscal year; but they may also play out over a longer time horizon.  For companies in highly cyclical industries, analysts often try to deduce a notion of mid-cycle earnings, to mitigate the temptation to take an overly optimistic or pessimistic view of companies’ potential to generate future free cash flow just based on where in an economic cycle we happen to be.

Part of the fun of investment analysis is that companies like to argue that negative performance is generally due to non-recurring factors — and that they are actually brilliant managers if earnings are measured on a Double-Secret-Adjusted basis that, in the company’s unbiased view, represents a true picture of the earnings power of the company.  When performance is unusually positive, however, the brilliance of management needs no further qualification.

Why do I bring this up?

Generally, I think it’s useful to distinguish between the recurring and non-recurring factors that influence one’s life in various ways.  Is your credit card bill high because you just moved into a new apartment, or because you are updating your wardrobe for every season?  Are you striking out romantically because you haven’t been compatible with your last few dates, or because there’s some deeper barrier to intimacy?  This is common sense wrapped in Wall Street jargon.

Specifically, though, the WSJ had a brilliant piece this past weekend that argues that the absence of this type of analysis from debates about public finances, taxes, spending, the deficit, etc., has helped bring America to its current precarious fiscal position.  Partisans of all stripes are guilty, which made this essay a refreshing if grim change from the typical rehash of religious arguments about what constitutes a “fair” distribution of income or a “right” size for the state.

As a starting point for my own opinions, which I’ll get to next time, I’ve provided the background above to show why I think it’s troubling (if not surprising) to consider that those in charge of the public purse consistently make the rookie analyst mistake of confusing the self-interested account of Double-Secret-Adjusted earnings with a more sober view of normalized financial performance.

If such mistakes would get a lowly analyst fired, why not our legislators?


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