Earnings are not always what they appear to be. When the environment deteriorates, as it has in 2020 due to the coronavirus crisis, management often tries to hide mistakes and confuse the truth. Bad news is delegated to unusual items, and before 2016, also to extraordinary charges or events that management classified as unusual and infrequent. Corporations encourage investors to focus on recurring income, so they gladly offer pro-forma income alongside GAAP earnings. Notice how the gap between adjusted earnings, the red line in figure 1, and actual earnings, the grey line, widens during troughs. However, these losses cost investors capital, so they should not be set aside without a cost and perhaps management should not collect their bonuses.
ISS’s EVA – economic value added – does not ignore these charges and other unusual items, but it does offer a compromise. EVA is the blue line in figures 1 and 2. ISS EVA methodology adds back unusual items to income and to capital. Since EVA is NOPAT minus a charge for capital based on the cost of capital, if the capital added back does not earn a proper return, or NOPAT, that offsets the charge, then EVA falls in future years (see full report). With this framework, management is given the benefit of the doubt that it is worthwhile, by adding it back in the year of the unusual item, but then needs to prove the expense yields results (higher NOPAT). If not, future EVA suffers, and since EVA growth is tied to stock returns, the stock probably does as well.
Figures 1-2: Management Tries to Hide Mistakes During Periods of Economic Troughs, but EVA Does Not Let Them Get Away with It
Source: ISS EVA (Investor Express) and FactSet data. Back-tests are run with FactSet Alpha Testing. Notes: Data includes aggregate values for all US stocks. The red line in the top figure is income before extraordinary charges, discontinued operations, and unusual items, but after dividends. The grey line in the top chart is income after dividends and the blue line in both figures is EVA. The red line in the bottom figure is changes in unusual items charge; notice how it varies inversely with EVA.
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By: Dr. G. Kevin Spellman, CFA; Senior Advisor, ISS EVA, & David O. Nicholas Director of Investment Management & Senior Lecturer, University of Wisconsin-Milwaukee Adjunct Professor, IE Business School
