A top accounting guru’s compelling new measure for profitability

Mar 10, 2014

Shawn Tully is an editor at large at Fortune

FORTUNE -- A big challenge for investors is piercing management’s feel-good, “it’s all great if you leave out the bad stuff” earnings metrics to measure a company’s true profitability. Even the official GAAP accounting numbers frequently need plenty of scrubbing to reveal the real picture. For example, many companies claim victory by boasting that their ratio of net profits to shareholders' equity is a big number. Investor beware: Management can hike “return on equity” by piling on debt, and high leverage makes the player riskier, not better. Another tactic, now in vogue, is moving factories that make the most profitable products to low-tax nations where the taxes may not remain low for long. That tax arbitrage provides a one- or two-time boost in earnings, but doesn’t prove management is running the basic businesses any better.

So what’s the best, gimmick-proof way to measure how profitable companies really are? Answering that question gets to Warren Buffett’s view of investing: Finding companies that consistently generate big returns on capital -- not only on the capital they manage now, but the fresh earnings that flow in each year. New investments that compound at double-digit rates are the ticket to fabulous performance for shareholders.

Jack Ciesielski, author of The Analyst's Accounting Observer, a newsletter prized by asset managers that skillfully demystifies accounting issues, has developed a fresh measure of profitability. His goal is to provide a clear view of managers' success in investing the capital entrusted to them by shareholders. He calls it “COROA,” for cash operating return on assets. The idea is to measure management’s ability to generate pure cash returns, not cash expected in the future, on every dollar invested in plants, R&D centers, inventories, and all other assets. “It makes sense for an investor to look at a firm’s cash generation ability, relative to the cash invested it,” Ciesielski wrote in the Feb. 25 edition of his newsletter, "The Analyst’s Accounting Observer." For Ciesielski, it’s all about cash. “What’s more important in the world than cash?” he asks. “Why, it’s more cash, of course.”

The first step is ascertaining true operating cash flows, meaning every dollar collected during the fiscal year. That’s not the number on the cash flow statement titled “cash flow from operating activities.” For Ciesielski, two factors distort that figure, making it an unreliable measure of true performance. First, official cash flow is calculated after cash income taxes, so that falling taxes can create the illusion of ongoing progress. Second, interest is also subtracted, and the size of the annual interest levy reflects the level of leverage, but has nothing to do with how well management is managing their assets.

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Hence, Ciesielski advocates adding back cash taxes and cash interest to calculate pure operating cash flows. Once again, that’s the dollar amount that the company actually puts in its coffers during the year. Those are the dollars that management has available to pay dividends, buy back stock, make “investments” by purchasing companies or divisions, and funding capital expenditures, especially those that propel growth. That’s the numerator.

The denominator consists of every dollar spent on the assets that produce those operating cash flows. To calculate that figure, take “total assets” from the balance sheet, and add “accumulated depreciation” to account for the plants or fabs still making cars or semiconductors that, for accounting purposes, are fully expensed. Fortunately, cash taxes, cash interest, and accumulated depreciation must be reported each year in the 10K, and loads of new information is just now being filed. For large companies, the deadline for 10K filings was March 4. So that investors can perform extremely up-to-date analysis.

The paramount metric is COROA, the operating cash flow as a percentage of total assets. For Ciesielski, that’s the best measure of pure profitability. If the number has been high for a while, and is either staying high or improving, evidence is strong that the company is generating strong returns from its new investments. That’s the quality that Buffett looks for.

Let's examine how one highly respected industrial conglomerate is performing, measured by COROA. Ciesielski applied his analysis to aerospace and controls manufacturer Honeywell Inc. by mining its recently released 10K, as well as reports from past years. He finds that Honeywell earned an 11.2% COROA in 2013, or $5.9 billion in operating cash flow on $52.8 billion in average assets over the twelve months. Its five-year COROA record is a tad lower than the average cash generation ratio posted in its peer group, which includes Raytheon , United Technologies , and General Dynamics .

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But it’s important to note that Honeywell’s number improved in 2013, strongly implying that its new investments are highly profitable. And it gained while Honeywell made major new investments that raised its assets by 11% from 2011 to 2013, or $5 billion. In that period, its operating cash flow rose by a remarkable $2.1 billion, or 55%. That doesn’t mean that Honeywell earned all of that increase on the new $5 billion in outlays on assets. It clearly must have managed its existing, and far larger, stock of inventories, research facilities and plants, and the workforce that runs them, extremely well. But the fat increase in operating cash flow compared to the far more modest rise in assets suggests that its new investments are highly lucrative -- once again the Buffett test.

Ciesielski probes even deeper, revealing in detail how Honeywell is investing in its highest-yielding businesses. The analysis is based on where Honeywell is putting its $950 million in annual capital expenditures. If capex is going mainly to the highest-yielding businesses, then managers are doing their job. If they’re excessively supporting subpar businesses, management is wasting capital.

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As the overall numbers prove, Honeywell passes the test. It operates four major divisions: automation and control, Aerospace, performance materials and technologies, and transportation systems. Aerospace and transportation provide COROAs of 28% each, while performance materials is a close third at 24%. Those are all big numbers. Automation and control trails at 14%. It appears that CEO David Cote is investing in the right places. He’s putting 12% of capex into transportation, which represents only 5.8% of total assets, but includes the fast-growing turbocharger business. He clearly sees performance materials as a comer: The unit that makes materials for computer chips and designs technologies for petroleum refining deploys 17% of the assets and gets almost half of all capex. By contrast, automation comprises over half the assets, and receives 17% of capex, reflecting its relatively modest profitability.

That strategy means transportation and materials are the big growth areas -- they will rise in importance relative to automation and controls. The aerospace business should keep its current footprint, since it absorbs the same proportion of capex that it employs in assets.

Ciesielski loves the source of all this information, and the only place it’s available: companies’ 10K filings. These documents’ encyclopedic nature, he says, makes them essential reading. “They give you all the information, not just what management would like you to see,” he says. “Don’t be intimidated by 10Ks. You can do this!”

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