http://www.earningspower.com

Conventional wisdom says a company has "earnings power" if net income is going up.

Conventional wisdom is sometimes wrong.

Why?

Because the published income statement has four structural limitations. The generally accepted accounting principles (GAAP) ledger 1) omits investment in fixed capital, 2) omits investment in working capital, 3) expenses intangibles like R&D and advertising, and 4) treats stockholders' equity as a source of cost-free financing. As a result, just because a company is profitable in the traditional sense of the word does not mean it has authentic earnings power.

How can you protect yourself?

Consider using the Earnings Power Chart, which employs two alternate income statements: a "defensive" to make sure the business can self-fund, and an "enterprising" to test whether it is creating value. The two are not the same, and strength in both is required for a company to qualify as a blue chip.

Benjamin Graham inspired the Earnings Power Chart. The chief aim of the defensive investor, Graham writes in The Intelligent Investor (Harper & Row, 1973), is to "avoid serious mistakes or losses," while the primary objective of the enterprising investor is to own a security "that is both sound and more attractive than average."

If you think the defensive investor is risk-adverse like a commercial banker, and the enterprising investor is more forward thinking like a venture capitalist, then you understand the differences between Graham's two personality types.

To illustrate the benefits of this dual approach, let's look at Enron Corporation.

Net income rose in 9 of 10 years ending 2000, which suggests the energy trader had earnings power. But in 2001 management said earlier profits were overstated, and it would also take a $1 billion charge to cover off-balance sheet losses. By year-end, Enron was in bankruptcy court. The stock, which reached $85 in mid-1999, was worthless.

We use a 3-step process to analyze Enron's earnings quality.

Step one is to build a defensive and enterprising income statement. In 2000, Enron was profitable according to GAAP, but it also suffered defensive losses, as we see below. The defensive income statement expenses investment in fixed and working capital, thereby fixing limitations #'s 1 and 2 of the GAAP income statement. Enron also had enterprising losses. The enterprising income statement capitalizes intangibles and expenses the imputed cost of stockholders' equity, thus fixing limitations #'s 3 and 4 of the GAAP income statement. We place the GAAP income statement between our two alternate versions to emphasize that it is too "enterprising" for the defensive investor, and too "defensive" for the enterprising investor.

Companies that generate defensive and enterprising profits are able to self-fund and create value. In 2000, Enron fell short on both counts despite chalking up record earnings.

 

Step two is to graphically depict defensive, GAAP and enterprising profits (losses). Enron had defensive and enterprising losses going back to at least 1996, as the chart below reveals.

Step three is to plot the intersection of defensive and enterprising profits (losses) in the Earnings Power Chart. The best box is the upper-right; the worst box is the lower-left. During the late-1990s, Enron was situated in the lower-left box. Enron did not possess earnings power the way Benjamin Graham might have thought about earnings power.

UnitedHealth Group also had robust earnings growth (GAAP) growth over several years. But unlike Enron, UnitedHealth generated defensive and enterprising profits, as we see below.

What's more, UnitedHealth is moving in an upper-right direction to forge an Earnings Power Staircase, so-named because of the distinctive "staircase-like" pattern created by the intersection of defensive and enterprising profits. When a company forges an Earnings Power Staircase, this is your hallmark of conservative growth. Not only is the company getting bigger, it is also getting better.

Shares of UnitedHealth are up 563% for the five years ending 2004, versus a 17% loss for the benchmark S&P 500. To view examples of other companies that have forged Earnings Power Staircases, click here.

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After getting wiped out early in his investing career, Benjamin Graham famously demanded a "margin of safety" to guard against further losses. Suspicious of income statements, Graham's idea of a protective cushion was to pay less than two-thirds of a firm's net tangible assets.

If you are looking for a conservative growth stock, do not expect the company to sell at a fraction of hard book value, as Graham sought. Growing businesses are rarely cheap. So use the Earnings Power Chart to make sure the company behind the stock is profitable in the broadest possible sense. This two-dimensional framework is your margin of safety. As the master carpenter tells his apprentice, "Measure twice, cut once."