Motley Fool Hidden Gems Investing - Lies My Income Statement Told Me

Episode Date: February 11, 2023

What’s the point of reading a company’s earnings report? Can’t AI do that job? Patrick Badolato, PhD, CPA is an Associate Professor at The University of Texas at Austin, McCombs School of Business where he teaches accounting and financial statement analysis. Badolato joined Ricky Mulvey to discuss: - How Walmart, Rent the Runway, and Peloton adjust earnings (and what it means for shareholders)  - Why investors should follow a company’s operating income - The pros and pitfalls of GAAP metrics - A better way to count stock-based comp. Companies Discussed: WMT, RENT, PTON Host: Ricky Mulvey Guest: Patrick Badolato Engineer: Tim Sparks Learn more about your ad choices. Visit megaphone.fm/adchoices

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This is a company that buys and then rents out fashionable clothing. But they also wanted us to effectively ignore the cost of their clothes by ignoring their depreciation on all of these items that clearly depreciate quite quickly and are a constant recurring use of cash to stay in business. I'm Chris Hill, and that's Patrick Bottolato, a professor at the UT Austin McCombs School of Business. Ricky Mulvey caught up with him to gain some insights from an actual MBA classroom and discuss whether artificial intelligence can take a financial analyst's job, why investors should pay close attention to operating income, and how Rent the Runway made an interesting adjustment to its earnings. One point in Howard Marks' memo, Sea Change, is that investors have this moving sidewalk

for the past 13 years, and that a lot of fundamental analysis wasn't really worth one's time. Now, in a more normalized interest rate environment, it might be worth your time. Walk me through this. Why is it worth it for investors to dig into the weeds in financial statements? Rick, I think one of the reasons is that slowly and surely, computers and AI and all that will replace what we do. And as a result, what I try to do in class is just to give a moment to slow things down, to let us have a chance to digest the information, as you said, read the footnotes and think carefully about what the business is doing. Alongside that, we're definitely going to use and talk about financial metrics, but financial metrics just can be very limited

where they give a snapshot of a company, they give a general overview, but there usually is much more behind the scenes that you can get from reading the management discussion analysis, looking through different parts of the footnotes or the rest of the financial filing. I mean, why can't a computer program... I've thought about this. Why can't a computer program just screen for metrics and then pick stocks for me? Look for companies with high returns on invested capital, low PE. Give me some examples and then let's go. At one point, this might be possible. And I love your question because we were recently talking in class about ChatGPT. And I'm actually excited about this because I feel like there's

a great opportunity for using more and more machine learning and AI to do the mindless mechanical stuff and then enable us as humans to continue to do the synthesis, do the analysis, weave together the qualitative with the quantitative. My belief is that that should really open up the door for more nuanced and thoughtful conversations around businesses instead of just trying to look for PE ratios or whatever else quick and dirty metric that we can find. I want to dig in to some of the metrics now, because I know there's a lot you've brought up in previous discussions that in your class with even MBA students, there's a lot of confusion about the difference between something like EBITDA and operating income. And that difference

is very important, not just for your students, but for investors. Yeah, it's a great point, Ricky, in that I think with students of all kinds of backgrounds and professionals as well, we're very colloquial with a bunch of our terms. And I don't mean in any way imply that the person using it, it doesn't understand what they're doing, but more along the lines of, I'm not certain we're always on the same page, as you mentioned, with metrics like EBIT, earnings before interest and taxes, operating income, or EBITDA. Let me just start that off by, I try to orient the conversation to talking about what do we want to get? What's the metric we're trying to analyze? Usually, that is the core performance of the business, which would

be revenue minus operating expenses. Commonly, people will call that EBIT, earnings before interest in taxes. But realistically speaking with companies, they're not going to be the same, particularly because there usually are other items between operating income and net income, other than interest in taxes, that you'd also want to consider or make adjustments for. So operating income lets us directly focus on the company's operations. But EBIT is really more constrained and may only give us the chance to make two adjustments for interest in taxes. Those are adjustments we may want to make in certain cases, but we might actually be including a variety of other items that we may not want to consider or would not be a

part of operating income. What are some examples then where EBIT doesn't give you a great picture of the company's financial picture? I'm going to talk about Walmart a little bit, but if you take Walmart over the last couple of years and you calculated their EBIT in a literal sense, earnings, and then you make an adjustment for interest and taxes and that's it, they've had a host of other items in there, Like other gains and losses, they had a loss on extinguishment of their debt. You can have a variety of factors that companies will encounter, gains, losses, commonly non-recurring items that will fall on the income statement between their net income and their operating income.

Just calling an operating income and focusing on what it literally is may just help that conversation move forward. I'll just give one example I've seen in class where I'll start with asking my students, hey, can you calculate EBIT for this particular company? And if I ask 100 students, what is EBIT for? In this case, actually, I did Walmart. You get about 40 different answers. You get a lot more consensus if you ask that same question with operating income. So, we do have some confusion with how we calculate EBIT and we have less of that with operating income. So, the benefit of operating income is that it's extraordinarily clear, revenue minus expenses, then you get your answer. That's one specific benefit I like of operating income. It's literal, it's direct, it's very clear about what we're after and the end result

are naturally matched together. So when people are talking about EBIT, they figuratively mean operating income. So then what's the benefit of finding that? Yeah, Ricky, I think that's really it, is that EBIT is usually defined to just mean operating income, even though it doesn't literally represent that. But it's still a useful metric to focus on operating income, particularly because it does a few things. One, it enables us to include all of the operating expenses. And two, it does allow us to strip out things that just might not be related to the company's core performance, such as interest, taxes, and importantly, other gains and losses or potentially one-time items that fall between operating income and

net income. I mean, if you're talking about stripping out expenses, then it sounds like you're just talking about EBITDA. So, what are the differences? Why are they important? Ricky, I'm glad you asked. I think that's just a good point here that we mix EBITDA in with conversations around operating income and EBIT, and EBITDA is such a common metric, it's absolutely worth trying to understand and unpack. A major difference here is that EBITDA starts to add back operating expenses, such as depreciation and amortization. And as a result, it may have some issues, and we definitely want to be careful with using this very common metric. All right. One reason that it's difficult to compare different companies' EBITDA and then

come to a conclusion is because of a stat like depreciation, which different companies use very differently. Sure. I think it's definitely worth examining the role of depreciation, which we're adjusting out or adding back in EBITDA. Here's one way to think about it. Companies that stay in business must constantly, constantly spend cash on maintenance capex to basically maintain their revenues and their expenses, the position that they're in. Say I run a grocery store and the refrigerator no longer works. I need to spend cash to replace that equipment, not to grow my revenue, but just to maintain my current revenue. If we consider a major retailer like Walmart, or even a smaller one with just dozens of

stores, they're surely spending cash to replace those assets that get used up just to maintain revenue on a weekly, if not daily basis. So this is a current, a constant use of cash in running a business. Recently, your show covered this point in a fascinating conversation with Warren Buffett's owner earnings, where he basically talks about the idea, the importance of removing off maintenance cap X, which is the amount we need to spend on property, plant, and equipment to maintain our revenue. This owner's earnings metric is absolutely great, excellent metric, but there's a big challenge for most of us, which is that we may not have the industry-specific knowledge to estimate

maintenance cap X, but I'd argue that not all is lost. What do we do if we're not the Warren Buffetts of the world? What if we don't have the experience that a Berkshire brings to the table? we actually have an excellent proxy for the recurring cash that a company needs to spend to maintain its position, and that is appreciation expense. So, we have an option here, basically. We can treat depreciation expense in a manner that's consistent with its economic basis. It's a core recurring operating expense that relates to recurring cash outflows, and just leave it in there. Outside of depreciation, there's some issues with comparability with that EBITDA number two, right?

Yeah. So, another issue you may find with EBITDA is that it actually can, in relatively common cases, impair comparability. So, let me set it up with an example that just covers a basic idea. Say you have two companies. One, basically, these are the same companies. I'm going to argue, in fact, all else is held equal. One company owns all of its stores. The other one rents all of its stores. If you calculate their EBITDA, the company that owns all of its stores is going to have a significantly higher EBITDA. The reason it'll be significantly higher is that they're able to ignore the effect, the cost of the stores that they own because they get to add back all their depreciation. So their EBITDA of the company that owns all the stores is going to look better.

But in many ways, these companies are the same. One just happens to rent and one happens to own. And as long as we're not talking about a real estate holding company, which would render this kind of not very useful, these companies are the same company and should be evaluated in a similar way. But EBITDA impairs comparability because it makes the one that owns look significantly better than the one that rents. So, operating income would kind of strip out that depreciation expense comparison. Yeah, and that's an important benefit of the lens that operating income can offer us when we're looking at a company's core business, is that whether a company owns or it rents, either of those expenses are going to be reflected in operating income. So, effectively, the company is going to be held accountable for owning or renting as a core recurring operating expense. One issue, too, with depreciation is that companies can often choose the useful life

for their assets, and that can be sort of gamed with their balance sheets. So, is that an issue, too, with looking at EBITDA? It's a really common idea that depreciation, the choice with useful life, a company can manipulate what they're doing with depreciation expense. And first, I want to acknowledge that's totally valid if we're looking at a single asset or a single project, not a collection of assets or a larger company. But mathematically, that issue is significantly mitigated once you go to the company level because companies have large collections of assets and their useful life or the amount

of depreciation expense each year. When it's done across a portfolio, it's going to greatly offset any impact they could make with respect to their choice of useful life. It's a somewhat technical calculation. I think it might be hard to do in a podcast, but effectively one way to look at it is that as long as the company has more assets than their average useful life. So let's take Walmart. Walmart's average useful life is between one and 40 years on its recent 10K filing. So we just need Walmart to have greater than 40, let's take the highest one, greater than 40 assets

and any choice they make with useful life will be effectively mitigated. Walmart has over 10,000 stores and over 500 in the state of Texas. So I'm fully confident that they're going to have such a large portfolio or bundle of assets that the argument about useful life, which does make sense with a single asset and totally works, is not going to be an item that affects the total company annual depreciation expense for Walmart or really any company with a collection of assets at its disposal. Yeah, but depreciation can get a little tricky once you start counting it as your cost of goods sold. We'll get to that in a sec. We've thrown a lot of word salad at you. What's the big takeaway, Patrick. I love that example, Ricky, and we'll get into it. But here's my

intentionally tongue-in-cheek version of it all. While EBITDA may violate the maintenance of finance by ignoring core recurring cash flows or overstating our operating income, it definitely still abides by the main tenets of humanity. Whether you go back to Plato's Allegory of the Cave or Facetune that we used today, or check out Warren Buffett's appendix in his 1986 letter, there always is an incentive for us to embellish, to be involved in marketing. And EBITDA is common and will continue to be common because it enables us effectively to ignore expenses and in different ways, embellish overall performance. Companies have an ability to add back certain expenses. And there is a set of rules that

they're supposed to follow with their income statements. It's called GAAP. And something that I've thought is, wouldn't it just be easier if all these companies followed the same rules? Ricky, that's a great point. And first, just to be clear, all these companies do follow the same rules. They have GAAP financial statements and they're never allowed to remove those. But what they are allowed to do, and I'm an accounting professor and I'm such a huge fan of, is to offer in addition to that non-GAAP metrics, right? Where they're allowed in that case to supplement the GAAP financial statement information with

additional metrics. And this is an opportunity for management to show their lens of the incremental information they have that might be better than we get from a purely standardized version with GAAP. One of the reasons this is particularly valuable is that in valuation in different applications, we actually don't want to treat each component of earnings or cash flows to be the same. There's a couple of academic papers that show this, but the basic idea is we as outsiders, like set-aside management, we want to focus on core earnings, like the recurring ability for a company to continue to operate and to generate performance that lasts over time,

meaning stripping out one-time items. So, what's a time that an adjustment has been useful? What's an example of a useful adjustment that offers clear insights for investors? I'm going to use an example with Walmart's recent 2022 fiscal year end. They have what they call adjusted earnings per share. And this would probably be easier with a slide, but let's give it a shot in this format. Walmart has back four items. And I want to talk about them and then kind of give a discussion around each of those items. First, the loss on the sale of their operations in the UK and Japan. Second, their loss on extinguishment of debt. Third, their unrealized gains and losses on equity investments. And fourth, their business

restructuring charges. Why are these important? Yeah. So, one at a time, I would say that these are the first one, the loss on the sale of operations in UK and Japan. This is like such a classic and great example in a classroom setting or anything else of a non-recurring items. If they sell these operations, they can really only sell them once. Second one, while they could theoretically have another loss on the extinguishment of debt, and think of this for us as like refinancing our mortgage, you could technically do this multiple times, although that would likely be rare. And in their case, they're getting out of that debt.

This is a good example of an item that's likely not recurring often, and certainly, and I think more importantly, not a part of their operations. Third, the unrealized gains and losses is actually an item that they have every year. But what they do, and I value their decision here, is they remove both gains and losses. So when this position is a net gain, they're adjusting that out. When it's a net loss, they're adjusting that out. So they're offering some insight into the idea that this is outside of their core operations. The fourth one is, I think, a great opportunity for us as humans to be involved in this process

in a way that AI might not be there yet. And it's the restructuring expense. On one hand, you could argue, well, this restructuring project is done. it's completed and it can't recur. But on the other hand, if you take a big conglomerate like Walmart, it's very likely that they'll engage in restructuring in the future. In fact, in some ways, you may want that to happen because the company needs to change and adapt across time. So, it's small. It's by far the smallest of all four. I think it adds six cents in total to the earnings per share and the rest collectively are $1.53. But I would personally say that I'm less

keen on ignoring that one. And I might want to leave it in earnings with the assumption that restructuring may recur often enough that we want to evaluate their performance with some amount of restructuring expense in each year. So of the four items, in my worldview, three of them make sense because they're one time outside of operations, or at least they're being balanced. The fourth one I think is up for debate, and you can take it in either direction. Do you want to let them adjust out restructuring or not? I think any human can have that conversation and use the information available and read what Walmart has to say about why they did it and what else is going on to make an assessment of whether or not that will occur. But collectively, I really like and

value what Walmart's doing because they're basically enabling us as outsiders to get at a better version of core earnings, which is like the recurring component of their earnings per share. The ones that we would expect to recur in the future and can naturally build into a forecast or a model or anything else. Plus, restructuring keeps companies like McKinsey in business. We always love to see small businesses excel. There are ways that these adjustments can be used, though, and it's not always a debate about whether or not this is a one-time expense. Yeah, non-GAAP definitely opens up the door for almost anything.

So, we'd be fairly naive to not expect some absurd embellishments to go on in this area. So, what are some of the less credible ways that you've seen companies adjust their earnings? There's lots of versions, and I'm going to intentionally find one that I've used in class, which I'll offer kind of particularly fun to do. So, Rent the Runway is a company that rents out its clothing, high fashion clothing, usually for major significant events in people's lives, what they did is they basically followed generally accepted embellishments of EBITDA, and they added back their rental product depreciation in their non-GAAP metrics. Again, this is non-GAAP, so it's certainly allowed. It's a

perspective they're able to offer. I just want to slow this down for a second. This is a company that buys and then rents out fashionable clothing, but they also wanted us to effectively ignore the cost of their clothes by ignoring their depreciation on all of these items that clearly depreciate quite quickly and are a constant recurring use of cash to stay in business. So how should Rent the Runway count the purchase of these high fashion items? Well, they're ignoring the depreciation on these, but I'd argue if we step back and think about what depreciation is for them, it's effectively their cost of goods sold. They're renting, they're not literally selling, but depreciation expense is effectively their cost of goods sold.

I think it'd be crazy for any other company, let's jump back to Walmart because we've been talking about them, to make an argument to outsiders and investors that we should evaluate them independent of or adjusting out their cost of goods sold. Fair enough. I can see why investors might want to pay attention to that. Before we wrap up, are there any other examples of companies adjusting earnings in ways that make you raise your eyebrows? Ricky, there's lots of examples, and there's one that we've chatted about and you guys have covered on your show, so it's gotten a lot of time and media attention.

I just want to bring up quickly, which is Peloton uses a version of adjusted EBITDA. And in general, what they do seems very similar to others, but I just want to make one point here. In their adjusted EBITDA, they're effectively removing, ignoring the effects of depreciation like many others. But a question to ask is whether an incremental push towards a metric like EBITDA or adjusted EBITDA can change the framework that management makes when they think about deploying capital. In 2021, Peloton added a massive new factory, which would come on board in 2023.

And if they're managing to a metric like EBITDA, which lets them ignore depreciation, it's just worth considering whether or not that incrementally pushes towards the deployment of capital that doesn't actually create value in the long run. effectively if they're not being held accountable for the capital they deploy in additional factories or warehouses or overall production. And the biggest adjustment that a lot of companies make to that EBITDA is stock-based compensation. What's your take on the ways that companies adjust for that? So especially as we move towards more of a human capital intensive economy, we've seen the rise

of salaries and wages basically being just a bigger part of companies' overall expenses. and alongside that, a rise of stock-based compensation. One common reason stock-based compensation is added back is actually the same as depreciation. We argue it's a non-cash expense. While it definitely is non-cash in the sense of a journal entry, as in we don't credit the cash account, we record it, but that's true of basically all expenses where we debit cost of goods sold and credit inventory or we debit wages expense and we credit wages payable.

most expenses don't have a literal direct credit to the cash account. So stock compensation is very much similar to compensation expense itself, except that the impact on the company may come later. So it's an expense that's commonly ignored. And it's just one we may want to take a little bit more careful look at, specifically because what it will naturally do is create dilution down the road. And so that as you're giving out a bunch of shares of compensation to your employees, your number of shares outstanding is going to increase. If I can use a quick numerical example, if I have a $100 company value and 20 shares outstanding, my price per share is $5. But if I give out an incremental $5 or five shares,

then I'll have 25 shares outstanding. With 25 shares outstanding instead of 20, my price per share all else held equal is going to drop to $4. So, stock-based compensation is a great example of an expense that's going to have an impact on the company's value. Particularly, it's going to increase the number of shares outstanding. We could try to model this in by adjusting for the expected increase in the shares outstanding, but that might be a very hard task. Another way to look at this is to examine stock-based compensation expense effectively as a regular expense, salary and wage expense that companies incur, representing resources consumed in order to run their business in that particular period. Even if the cash flows are

delayed, or even if the impact on valuation is slightly delayed, it's still a representation of resources consumed to run the business in that particular period. Patrick Matalato, he is an accounting professor at the University of Texas McCombs School of Business. Stay warm down there in Austin and appreciate your time and for joining us on Motley Fool Money. Thank you, Reagan. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.