Income Statement Use in Value Investing
Classic value investing focuses on balance sheet with an understanding that in most industries, earnings power has no value as over time, competition and threats of substitution erodes any competitive advantage the company may possess. While this may be true, income statement should never be ignored. There are a few situations where they become critical to determine soundness of an investment.
Situation 1: We find an undervalued company based on balance sheet analysis
If a company is undervalued in the market based on the balance sheet review, one must look at the profit generation ability of the company to make sure that the company is not generating losses at a rate that will eat away any value in the balance sheet quickly. Quite a few stocks are beaten down to below tangible book value as the company continues to rake up losses. In these situations, a value investor must dig deeper as to the cause of losses and make a determination if the situation is temporary and will reverse. In absence of any mitigating catalyst, it is wise to stay away from that investment.
Situation 2: The company is showing above normal profitability compared to industry and its history
This typically results from one off events such as asset disposition where the company may record the market value of the asset disposed which is above the depreciated carrying value. In these situations, the effect of the one time events must be isolated and the income statement adjusted to determine a “steady state” view of the business. This is straight forward when comparing with historical performance – however, going forward, one needs to recognize that the income generating capability of this asset is no longer there.
If the investor uses traditional valuation metrics such as P/E ratios, it is vital to look deeper into the income statement to make sure that the P/E ratio is not artificially low due to these one off events.
Situation 3: The company consistently shows above normal profitability compared to the industry
This is the situation that is of interest to a value investor that has decided to seek value in the earnings power of the company, as opposed to the classical value investing process. This may indicate some sort of moat or a competitive advantage that this company may possess that allows it to generate higher profit margins. Perhaps the competitive advantage lies in the pricing power or perhaps the company has a cost advantage. In either case, the investor needs to ascertain if this competitive advantage is likely to persist in the future in face of competition and technological advancement. In a previous article I described how SWOT analysis can help determine whether the competitive advantage is likely to persist or not.
If the stock is not undervalued based on balance sheet review, but there is a competitive advantage that can be sustained, than a careful review of the the company’s earnings power is warranted as the ability to generate above average profits year after year creates a source of value that should be considered.
In the next article in the series we will explore the topic of value in the earnings power. Stay tuned.