Can you "even the playing field"? Check out these key metrics that make earnings more accurate!

Wednesday: The Independent Investor FROM THE DESK OF MILES EVERSON: Welcome to today’s edition of “The Independent Investor!” Every Wednesday, we talk about various investing tips, strategies, insights, and advice. Our goal in writing and publishing these articles is to help you strategically think about your financial choices and achieve true financial freedom in the long term. In this article, we’ll focus on one of the methods Professor Joel Litman and his team uses at Altimetry Financial Research. Are you ready? Keep reading to learn how you can better look at the cash flows of the companies you’re planning to invest in. CEO, MBO Partners Chairman of the Advisory Board, The I Institute

Can you "even the playing field"? Check out these key metrics that make earnings more accurate! Imagine you’re a part of a large research firm… You and your team are conducting hundreds of thousands of analyses about different companies, and so far, your outputs are appreciated by many. … but what if one day, someone points out a discrepancy in your research methods? How would you react? Would you… Lash out at that person and tell him/her that you didn’t spend lots of hours working only to be told there’s a disparity in your research? Ignore that person’s comment? Accept the feedback and explain to that person how you actually do your research? In May 2023, Professor Joel Litman, Chairman and CEO of Valens Research and Chief Investment Strategist at Altimetry Financial Research, and his team experienced a similar scenario. One of Altimetry’s subscribers noticed something critical and pointed out what seemed like a BIG discrepancy in Professor Litman and his team’s research methods. However, as we’ll explain in this article, this “discrepancy” is actually a deliberate action on the team’s end. The Truth About Uniform Accounting Professor Litman and his team often say Uniform Accounting is all about making earnings more accurate. This involves removing the “noise” from corporate earnings, and most of the time, the team relies on an entirely different metric: Return on assets (ROA). ROA enables analysts to look at a company’s profitability in a way that’s comparable with its peers. For instance: When a company grows or shrinks, its earnings change. Why? One needs assets to generate money, so it stands to reason that larger companies should be able to earn more money. However, Professor Litman states just because a company is growing its earnings doesn’t mean it’s becoming a better business. The business model dictates a lot of factors, like how much earnings grow relative to assets and how fast the company can grow overall. For example: Utility companies can grow their earnings by building new power plants. However, utilities are heavily regulated. Their profits are capped by the government to make sure energy is affordable. This means no matter how many power plants a utility company builds, its earnings will grow in proportion to assets. Meanwhile, software companies can grow their earnings faster than they grow their asset bases. The reason is because software is a digital product. Selling 10 million copies of software doesn't take 10 times more assets than selling 1 million copies. So, as software companies grow their earnings, they tend to get more profitable. Professor Litman says by starting their analysis with Uniform ROA and asset growth, he and his team see how the business model impacts a firm’s profits and growth. That’s a powerful context when modeling future returns! In fact, Professor Litman believes comparable-peer profitability is one of the best indicators for future performance… and for this reason, Uniform ROA is VERY IMPORTANT. By knowing that the corporate average Uniform ROA is 12%, Professor Litman and his team understand what reasonable profitability is. A Better Way to Look at Cash Flows Through Uniform Accounting Uniform ROA "evens the playing field." This enables analysts to properly compare a company with its peers, regardless of whether that company is a lot larger or a lot smaller. At Altimetry, Professor Litman and his team use Uniform ROA and asset growth to calculate cash flows. By combining these two key drivers, the team is able to identify a company’s cash flow. Another tool the team uses to break down thousands of companies is the Short-Term Embedded Expectations Analysis (EEA), which translates Uniform ROA and asset growth into Uniform Earnings. Professor Litman and his team simply multiply Uniform ROA by Uniform assets to calculate a company’s earnings. Here’s an example of restaurant chain Shake Shack's Uniform Earnings in May 2023 to demonstrate such an analysis… According to Professor Litman, the market expects Shake Shack to reach 10% Uniform ROA in five years, with 12.5% annual Uniform asset growth. This means the firm’s assets are expected to reach USD 1.5 billion by 2027. Investors think the brand’s earnings will reach about USD 150 million (10% multiplied by USD 1.5 billion). So, Shake Shack, whose Uniform Earnings capped out at USD 40 million historically, has to grow its earnings to roughly USD 150 million just to be fairly valued. Professor Litman states that’s a steep acceleration. The company would have to step up its game quickly to justify such valuations. That’s why hedge fund Engaged Capital has begun its activist campaign. It thinks it can get Shake Shack back on track… and push the company to grow earnings like never before. It has the chance to meet (or even beat) investors’ expectations. However, this analysis has to end with cleaned-up cash flows… and according to Professor Litman, that’s what makes the EEA such a powerful framework. Through this, analysts can understand what the market expects a company to do AND determine if those forecasts are reasonable. We hope today’s topic helped you look at and analyze cash flows better! Remember: Uniform ROA and asset growth are important key drivers to help you get there. Both of these turbocharge your ability to understand the cash-flow analysis and identify whether or not a stock is worth your time and money. Hope you’ve found this week’s insights interesting and helpful.     Activist investing involves the acquisition of a significant stake in a publicly traded company to influence how it is run. Learn more about the importance of taking the “Activist Investor” view in next week’s article!