You know something is strange when a profitable business reports a deficit in equity. Take L Brands, Inc. (LB on the big board), the American fashion retailer. Between 2008 and 2017 the company profited a total of $9.3 billion. Its yearly profits ranged from as low as $220 million (in 2008) to as high as $1.2 billion (in 2015).
Yet if you carefully look at the net equity balance during this decade-long period, L Brands had an equity balance of $1.87 billion in 2008 and as of its most recent filing the company reported a $753 million deficit. With a deficit in equity, there is little for the analyst to calculate. And results from calculating profitability ratios such as return on equity ratio become senseless.
When the equity balance is in the red, trying to understand the company's leveraged position by finding the ratio of debt to equity results in silly, illogical numbers. And what a deficit in the equity balance really tells us that if the company was to sell its assets what would remain for the common stock holders is in fact nil.
Instead of reflecting on the peculiar GAAP accounting, of how a profitable enterprise reports on a deficit in the equity balance, let us ask what can we do about it?
There are two techniques. The first technique is to substitute the equity with the tangible assets of the firm. So to measure profitability for example, we calculate net income in the nominator and tangible assets in the denominator. The same can be done for to find the leverage ratios. Instead of relying on the total liabilities to equity balance ratio, we calculate total liabilities to tangible assets.
The second technique, somewhat more elaborate than the first, evolves around the adjustment of non-cash items such as impairment loss from the reported equity balance.
As of the fiscal year end 2017 annual report, L Brands tells us that of its $8.15 billion in reported assets, $3.15 billion relate to Goodwill (the premium paid above fair value price of a company) and $411 million in trade names.
If we remove the two intangible assets, we find assets valued at $6.39 billion, which includes $2.89 billion in property (L Brands owns many of its retail stores) and $3.29 billion in current assets. Using the reported profit of $983 million we find a return on capital of about 15%. We can apply the same technique for the 2016 results and find a return on capital of 18%.
To calculate the company's leverage, we will again remove the intangible assets from the company's reported assets. And with reported liabilities of $8.9 billion for 2017, for every dollar of assets we conclude that L Brands leverages a dollar and 39 cents. For 2016 the adjusted assets were $6.41 billion and total liabilities were $8.90. Again we find that for every dollar of assets, the company used a dollar and 39 cents of debt.
By replacing the equity with adjusted assets, we get a better sense of the company at hand. We can now proclaim: L Brands was able to generate a reasonable profit on its invested capital. But it had done so by taking a surmount level of debt obligations.
In 2017 L Brands had retired $1.93 billion of its common stock. To retire the stock simply means that L Brands had purchased its owns common shares in the marketplace. But instead of keeping the common shares, what is classified in the accounting profession as treasury stock, management retired the stock it bought which means it cannot sell the stock in the future. From that naive practice, the retained earnings balance took a hit of $1.93 billion, resulting in a deficit of $1.43 billion.
So Treasury stock is the second adjustment to reported book value. In If the return on equity is too good to be true, then it probably is ,I showed how to adjust for treasury stock using the balance sheet of IBM and Colgate. I will not repeat the math but instead add back the average cost of the shares that were purchased. We get an equity balance of $2.4 billion in 2017 and an equity balance of $1.96 billion in 2016.
We now see that using the equity adjustment technique the 2017 return on equity was 41% and the 2106 return on equity was 59%. Again these rich ratios are the result of management's appetite for debt. And as any financial institution knows, the more debt the company uses, the higher the return on equity.
"Proper accounting is like engineering," notes Charlie Munger. "You need a margin of safety. Thank God we don't design bridges and airplanes the way we do accounting."
Not enough investors know and understand that the accounting profession often mandates nonsensical reporting. I think many investors treat the financial records of publicly traded companies as if they are pure, self-evident numbers that follow clear and logical accounting laws.
Yet nothing could be further from the truth. As a matter of fact, financial records are loaded with assumptions and are full of management’s decisions of how to represent the economics of its business.
My purpose in this meditation is to remind the reader that just as a medical student needs to understand the body's anatomy prior to performing surgery, so must the stock investor understand accounting conventions. And more important, that the conventions are merely the starting point to understand the company’s economic reality. As a wise sage once said: accountants know how to count; investors should know what counts.