Part 8 of the "Dirty 30" evaluation tool has arrived! This is the second to last post of the series and hopefully another learning experience about one of my favorite tools that I use to evaluate stocks before I decide whether to take a position.
Today we will be digging into the EARNINGS section of the evaluation. This section is one of the most important so do not think for a minute that because it has been left until part 8 that it is trivial. That is just not the case. As always I have embedded the Hormel (HRL) evaluation below for you to peruse. If you have not read parts 1-7 then you can find them here.
EBITDA is an acronym that stands for Earnings before Interest, Taxes, Depreciation, and Amortization.
"I know what the first two are but what is depreciation and amortization"
That is a very good question. To know what the entire picture looks like we must first know what are the pieces to the puzzle.
Depreciation is a fancy word for how much value an asset you own is using. This, in business, can be written off each year. For example if I purchase a piece of tech equipment with a 10 year life span for $10,000 dollars and I know that I can scrap parts for $1000 at any time in the future then the depreciation for this asset is $9000 dollars over 10 years. This means that I can write off $900 dollars each year. This can change the looks of my earnings to some degree.
Amortization is probably a bit easier concept to comprehend. Amortization is paying off an asset over a period of time with fixed payments. Sound like a car or mortgage payment to you? Good because that is exactly what it is! This can make a difference when looking at earnings because a yearly expense for an asset that will be worth something to sell (such as your house) can be a really good thing. Unfortunately this also can skew your earnings. Think about your payments. How much would your yearly earnings be without the mortgage? Now how about the net worth? The answer to this question is why amortization is important to remove from earnings.
A quick touch on taxes and interest and the reason they are taken out with the EBITDA equation. Both of these can be variable over a lifespan of a company and have no real impact on the operating profit of the company. Taxes can be affected by laws, deductions, accounting slight of hand, and so much more. Interest can change do to rates and total loan exposure. Neither of these have an effect on operating income but can effect the total EPS.
So in summary EBITDA is a very simple way to look at how a company is progressing its operating profit on a year to year basis. This takes out all of the accounting mess and gives you a more honest look at what goes into its operating cost and income.
I also look at diluted EPS. Diluted EPS contains the earnings per share when all things that could be converted to common shares are included. These include convertible securities, convertible debentures, employee stock options, and warrants. More simply put, this is the worst case scenario of the earnings per share. This is important to look at as a company could have a decreasing diluted EPS due to issuing plenty of options to their employees as bonuses. This may not sound like a terrible thing but it could be a factor when those employees decide to act on those options.
It is also important for me to compare the diluted EPS to the EBITDA. If one is rising while the other is falling it points me in a direction of inquiry. It is definitely something I need to look into.
DILUTED AVERAGE SHARES
This goes along the same line as the diluted EPS. If these shares are going up in a mature company that is probably not a good thing. First off it means that they will have to have a higher net income to reach the previous EPS number and also it means that they may be doing some slight of hand behind the scenes in terms of payment to employees or loans. This raises a flag for me of a potential problem. If it is decreasing then I am loving it! This means that the stock could potentially rise without even making a dime more in net income!
As you can see while earnings may look really confusing (and sometimes it is) if you break it down to these three metrics you get a much clearer look at just how a company is performing. Are they actually earning more or less? Is the EPS affected only by number of shares? Is there potentially something shady going on that warrants more research? These are all questions that can be answered after looking at these simple metrics.
As always I hope you enjoyed a look into my evaluation tool and please feel free to leave any comments below.