How to invest

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Jae Jun

How to value stocks series

For other posts in the series, follow the links below.

• How to value a stock with DCF Method
• How to value a stock with Benjamin Graham Formula
• How to value a stock with Reverse DCF
• How to value a stock with EPV
• Value Stocks Like a Pro. The Absolute PE Method.

It’s been a long time coming but I’m finally getting around to reverse engineering the absolute PE valuation model that Vitaliy Katsenelson created and explains in his book Active Value Investing.

If you haven’t read the book, check out my review of Active Value Investing. If you want to value stocks the way Katsenelson does, it certainly is worth the read.

From this point onward, you may need to slow down your reading as you process the methodology and think through how it all comes together. Nothing is new here. All of the information is directly from the book.

Vitaliy Katsenelson’s Absolute P/E Model

This model derives the intrinsic value of the stock based on the following five conditions.

1. Earnings growth rate
2. Dividend yield
3. Business risk
4. Financial risk
5. and earnings visibility

Core Principles of the Absolute P/E Model

No Growth PE

Part of the reason why I created the no growth PE screen backtest was for the purpose of this valuation method. I needed to know whether my conservative nature of using a PE of 7 for no growth was factually correct. My results show that a PE range of 7 to 8.5 is perfectly acceptable so you are free to use whatever suits you.

Graham used 8.5 in his Ben Graham formula, and Katsenelson uses a PE of 8 in the book. I’m going to stick with my PE of 7 because if you flip the PE over, I get an earnings yield of 14.2% compared to 11.8% and 12.5% for Graham and Katsenelson respectively.

With the small caps I analyze, demanding an earnings yield of 14.2% is better than 11.8% wouldn’t you say?

However, if I were to analyze large blue chips such as MSFT, I would be content to adjust the PE to 8.5.

Earnings Growth and PE Relationship

Logically, higher growth rates leads to a higher PE. However, this model does not have a linear relationship. The absolute PE model is set up so that for every percentage of earnings growth from 0% to 16%, the PE increases by 0.65 points instead of 1 point.

If the growth rate reaches a certain level, in this case 17%, the PE value is increased by 0.5 points. You have witnessed many times that the higher the growth rate, the greater the fall from the top.

Earnings growth projections are made for five years or longer and with higher earnings visibility, a higher PE factor is assigned.

Think of it this way, the earnings visibility of Coca Cola (NYSE:KO) or even Microsoft (NASDAQ:MSFT) is clearer than Salesforce (NYSE:CRM) or a cyclical company such as Caterpillar (NYSE:CAT).

Value of Dividends

Dividends are tangible to the investor whereas earnings is not. Dividends provide you with a hard return whereas you may never get to see earnings. So in contrast to the non linear relationship between earnings growth and PE as shown in the table above, dividend yield and PE will have a linear relationship as shown in the table on the right side.

Every dividend yield percentage receives an equivalent PE point. If the dividend yield is below 1%, use a PE factor of 0.5.

PE Factors for Business & Financial Risk and Earnings Visibility

This part is the most subjective of the valuation model as it requires you to come up with a single number to summarize the risks and earnings visibility.

For business risk, you may want to consider the industry the company is in, the products, the life cycle, concentration of products and customers, environmental risks  and anything else related to the operations of the business.

The level of financial risk can be determined by examining the capital structure of the business as well as the strength of the cash flow in relation to debt and interest payments.

Earnings visibility is analyzed in  much the same way.

Below are the risk points to use in the model.

• For an average company, you will want to assign a value of 1.
• For a market leader, select a number less than 1. If you believe a market leader deserves a 10% premium, then use a value of 0.9. If a 15% premium is deserved, then 0.85 is the number to use.
• For a market lagger, select a number greater than 1. Poor companies should be discounted. A 20% discount requirement means a value of 1.2 will be used.

Qualitative Aspects of the Absolute PE Value Model

Before moving onto examples of how this model is used, a couple of points made in the book should be considered.

Put a ceiling on growth

Based on the business risk, financial risk and earnings visibility, additional PE points are added to the basic PE.

For example if a company is expected to have 10% earnings growth with 0% dividend yield, according to the table above, I would assign it a PE of 13.5.

Now, depending on how good the company is, additional PE points are added based on business risk, financial risk and earnings visibility.

Katsenelson writes that he limits the premium to the basic PE to be no more than 30%. In other words, if the basic PE is 13.5, despite how good the company is, the final adjusted PE won’t be more than 17.55 (13.5 x 1.3=17.55). If the basic PE is 10, then the ceiling will be limited to PE 13.

Inflation and interest rates

The model assumes that inflation and interest rates are average and not expected to increase or decrease to dramatic new levels.

In the current environment, interest rates are low with possibility of inflation. If inflation and interest rates are expected to rise, then the zero growth PE should be adjusted down and vice versa. There is a caution against using current interest rates without considering the long term direction.

This is the PE Model Formula

You now have the PE table to determine the basic PE as well as the understanding of the risk points for business, financial risk and earnings visibility.

Now let’s put it to use.

The formula to calculate the intrinsic value PE is the following:

Fair Value PE = Basic PE x [1 + (1 - Business Risk)] x [1 + (1 - Financial Risk)] x [1 + (1 - Earnings Visibility)]

Testing out the Valuation on 3 Stocks: WMT, TGT & SVU

Let’s use Wal-Mart (NYSE:WMT) as an example.

Wal-Mart is the industry leader in retailing. Strong balance sheet, huge competitive advantage capable of swallowing any small competitor. Consistent dividend payouts, FCF cow, stable margins, CROIC of 8% with ROE of 20% makes this one of the best retailers in the world. Debt isn’t an issue as FCF can cover all interest payments. It also makes earnings growth and visibility easier to determine.

Based on the past 5 year median EPS growth, WMT achieved 11% earnings growth which sounds about right. Although WMT is the best of breed, I’ve only given it a 5% premium for the business as retail is still a tough competitive industry to be in.

• Expected Earnings Growth: 5%
• Dividend Yield: 2.75%
• Business Risk: 0.95
• Financial Risk: 0.95
• Earnings Visibility: 1.0

As you can see, for a great business such as WMT, the fair value PE is 18.63. Make a note to apply a maximum premium of 30% to the basic PE which means that the final fair value PE should be capped at 21.97. However, since WMT is in the retailing business, I could have put the business risk as just 1.00 not giving it any premium due to the nature of the industry.

According to this calculation WMT is priced attractively with its current PE of 12.33.

How about Target (NYSE:TGT)?

Definitely number two behind Wal-Mart. Margins are solid and consistent, with a sub par CROIC of 3.6% over the past five years. ROE of 17% and no issues with debt of financial risks. Earnings growth however has been a lackluster 5% and likely will be the same.

• Expected Earnings Growth: 5%
• Dividend Yield: 2.56%
• Business Risk: 1.00
• Financial Risk: 0.95
• Earnings Visibility: 1.0

Looks to be fairly valued at the moment with TGT trading at a PE of 11.42.

On the other side of the Spectrum is SuperValu (NYSE:SVU).

A company in a turnaround process with fluctuating returns, margins and earnings. Definitely the lagger of this group.

• Expected Earnings Growth: 8%
• Dividend Yield: 3.95%
• Business Risk: 1.10
• Financial Risk: 1.00
• Earnings Visibility: 1.10

SVU is much harder to analyze with PE because of the negative EPS. However, if I use the 2011 FCF figure and divide it by shares outstanding to apply Buffett’s “owner earnings” concept, owner earnings comes to $2.67. Multiple this by 13.09 to get a fair value of $35 share price.

Quite a difference to the $8.84 it is trading at now, and I’m sure I made mistakes by just grabbing the FCF figure so I’ll leave it up to you to check.

Summing Up

I don’t focus much on multiples but after using this valuation method a few times, I’m beginning to like it. It’s quick and easy method to value stocks without having to know the current price of the stock.

The model does have subjectivity and the results will end up being only as good as the inputs, but it’s a technique that anyone can learn and apply.

Disclosure: None.

Theodor Tonca

One of the questions I have frequently been asked lately is, “How do you analyze businesses?” I usually respond by noting that determining a company’s intrinsic value is a subjective operation. It is nearly impossible to determine a company’s precise value but it is not hard to determine its approximate value and that is the aim, to be approximately right and not precisely wrong.

With that in mind, I think the following will be helpful to anyone that is interested in learning how to properly analyze potential investments from a value perspective.

How to value stocks series

For other posts in the series, follow the links below.

• How to value a stock with DCF Method
• How to value a stock with Benjamin Graham Formula
• How to value a stock with Reverse DCF
• How to value a stock with EPV
• 3 Quick and Easy Valuation Methods

What is Value Investing?

Value investing in the manner initially defined by Benjamin Graham & David Dodd entails the strategy of purchasing securities only when their market prices are significantly below the calculated intrinsic value.

This difference between value and price is thought of as buying with a “margin of safety”. The objective is to purchase a proverbial dollar for 50 cents or less.

While the objective is simple, the actual task is anything but. The goal of this article is to show one how they can assess with reasonable certainty the approximate intrinsic value of potential investment targets.

Here are a few of the simplest and most accurate methods which I have personally utilized for the past five and half years to get one started in determining a company’s intrinsic value:

Asset Based Valuation using NCAV

NCAV (Net Current Asset Value) shows how to calculate the classic “Net-Net” as utilized by the father of value investing Benjamin Graham himself.

Current Assets – Total Liabilities = NCAV

This is both the simplest and most conservative estimate of a company’s intrinsic asset value. As a rule, Benjamin Graham only looked to purchase company’s which were valued at a discount to their net current asset value by 33% or more.

Today, value investors are hard pressed to find company’s valued at such a significant discount and would be happy to pay 100% net current asset value for a company and acquire both its earnings and any potential growth for free. This equates to essentially paying only liquidation value for a company and nothing more.

Asset Based Valuation using Reproduction Costs

This type of analysis requires much more specialized knowledge about both the business and the industry in which it participates.

In this instance we attempt to assign a value to each asset on the company’s balance sheet to determine what the inherent reproduction cost of all the asset is.

Example:

As you can plainly see from the example above, the liquidation value or reproduction costs of assets is usually far below what is stated on a corporate balance sheet. It is from the reproduction value figure that investors must deduct all liabilities to ascertain a company’s true asset value.

Again, when it comes to asserting reproduction values to assets the better one understands the company and the industry in which it operates the better (and more accurate) the estimate they can place on its assets.

Earnings Based Valuation using EPV

EPV (Earnings Power Value) is the most conservative earnings based valuation and hence why I utilize it as it falls in line with my foremost investment objective which is to maintain the safety of my principal.

Adjusted Earnings x 1/Cost of Capital = EPV

Earnings Power Value is what I believe to be the second most reliable measure of asserting a firm’s intrinsic value, behind estimates based on assets.

The simple goal of EPV is to accurately estimate the currently distributable cash flow of the company. To do this we analyze the earnings data and make adjustments where necessary.

For example:

After making adequate adjustments to the cost of goods sold, selling, general & admin, as well as depreciation & amortization which takes into account amounts actually spent on increasing sales and brand awareness while determining actual business expenses and costs more accurately, we arrive at the above stated figures.

After making these necessary adjustments and arriving at a more accurate earnings figure, all that remains to be done is simply assume that these cash flow figures will be sustained and experience no growth whatsoever.

We then divide this figure by a reasonably determined cost of capital (rate of interest at which the company can reasonably borrow money) to arrive at our EPV for the firm and thus its earnings based valuation.

By dealing only in current facts and figures and not relying whatsoever on future growth or cost of capital projections like a discounted cash flow analysis or the like would we arrive at a much safer valuation figure.

Growth Based Valuation

Like any value investor I would advise not paying anything for even the rosiest projections of future growth unless they have some basis in current and past figures.

If one does see stable growth then they must first, determine if the growth is taking place within the franchise and if the firm does indeed enjoy a competitive advantage in the marketplace. If this is found to be the case only then can a growth based valuation be estimated.

One such method is the Benjamin Graham Valuation method.

Benjamin Graham Valuation

EPS x 8.5 + 1.5G x 4.4/4.60 = V

(In depth look at Benjamin Graham Valuation)

EPS is the trailing 12 month’s earnings per share, 8.5 is the PE ratio of a stock with zero growth, G is the estimated growth rate for the next 5 years, 4.4 is the minimum required rate of return when investing, 4.60 is the current 20 year AAA corporate bond yield, V is the intrinsic value of the company.

This is the original growth valuation formula employed by Graham as described in Security Analysis.

However, be forewarned as this method of valuation is much riskier than both an asset or current earnings based valuation simply because of the fact that we are making projections about the future which are always extremely imprecise.

Summing Up

As always there is much more to be said about business analysis than contained in a brief article such as this, many more things to be considered and much more expertise to be imparted by those with much greater knowledge than myself.

However, I would like to add a few further words for consideration. Namely, that many insights can be gleaned from performing and then comparing asset, earnings and growth based valuations to one another.

Doing this will enable one to better understand certain qualitative aspects of the business in question, such as if the reproduction cost of the assets is greater than the EPV then in all likelihood, that implies that current management is not earning an adequate return on its current assets or it can also be that the industry in which the business is involved in is operating with excess capacity.

Further analysis can determine which of these scenarios is factual. Another very important thing to remember is to always perform a follow up analysis on companies held in your portfolio to ascertain if the initial reason you made your purchase is still valid. I usually do this on a half yearly basis.

This article was written by guest author, Theodor Tonca. If you would like to have an original article featured, please contact me via one of the methods below.

Jae Jun

How to value stocks series

For other posts in the series, follow the links below.

• How to value a stock with DCF Method
• How to value a stock with Benjamin Graham Formula
• How to value a stock with Reverse DCF
• How to value a stock with EPV

Disadvantages of Discounted Cash Flow Valuation

I am a fan of the discounted cash flow valuation method. It isn’t perfect, but it also isn’t as horrible as a lot of people make it out to be. With everything, there is a strength and weakness. As long as you are aware of each, a DCF model is a valuable tool to have in your belt.

But first, let’s quickly go over the main weaknesses of DCF.

1. Projecting Future Cash Flow

All evidence points out that humans cannot predict. This is no different when it comes to projecting the future cash flow of the business. There is too much uncertainty when trying to forecast and you are also basing the future values based on past results.

With such forecasting, a small error can result in a drastic change in the DCF valuation.

2. Calculating a Proper Discount Rate

Unless you have a good understanding of what a discount rate is, this value can lead to inaccurate assumptions. A big problem is that you may end up playing around with the discount rate to match the intrinsic value you are seeking.

3. Predicting Growth Rates

The main problem with determining a feasible growth rate is that a DCF will simulate the growth rate to be on-going. Unless you apply multiple stage DCF valuations, a single growth rate is usually used to project the growth for the next 10 years.

In my own stock valuation spreadsheets, I use a decay to reduce the growth rate every certain number of years. It’s not a 2 stage or 3 stage DCF model, but similar and simpler.

Reverse DCF Overview

What the reverse DCF attempts to do in order to improve from the reputation of its twin, is to eliminate the need to forecast.

Instead of starting with a given year’s FCF, and then projecting towards an unknown, the purpose of the reverse discounted cash flow is to calculate what growth rate the market is applying to the current stock price.

In other words, by working backwards, you can see whether the implied growth rate by the market is higher or lower than what the company is capable of.

Let’s see how it is actually done.

Reverse DCF Valuation of Microsoft (MSFT)

Using the DCF model from the premium stock valuation spreadsheets, set the discount rate to 9%.

My rule of thumb for large caps is to calculate the discount rate as

discount rate = risk free rate + risk premium

with the current risk free rate being approx 3.5%

large cap discount rate = 3.5% + 5% = 8.5%

and you can round up the 8.5% to 9%.

Now that you have the discount rate set to 9%, play around with the growth rate until you get a value that matches the current price.

On my spreadsheet, the growth rate has to be set to -2.6% for the reverse DCF valuation to match the current stock price.

(The -2.6% value should be used as a ballpark figure and not the gospel as my spreadsheets contains more customization than a regular straight line DCF.)

Click to enlarge image.

Here, you see that the market is currently pricing MSFT to have negative growth. Whether this is true or not is up to you, but it is definitely hard to imagine a free cash flow machine like MSFT shrinking year over year.

However, recent news of the drop in Windows OS sales and the purchase of Skype could very well prove to be an indication of a slowly declining business.

Reverse DCF Valuation of Cisco (CSCO)

With all the negative press and sentiment on CSCO, it couldn’t be more hated on Wall Street than now.

Sticking with the same discount rate of 9% as MSFT, the implied growth for CSCO is at a jaw dropping -9.6%

Again, this is a ball park figure, give +/- 2% to the final value.

The more important question now, is whether the business of CSCO really is going to continue slide at such speed.

Initial thoughts lead me to believe the answer is no.

Reverse DCF as a Point of Reference

So that’s how easy a reverse DCF can be applied. Just match the intrinsic value to the current price and ask yourself whether the growth rate makes any sense.

It simplifies the DCF thought process and output from “what is the future growth rate?”, to “is the expected growth rate realistic?”.

Always remember that the growth rate you end up with is a frame of reference that will help you with your research, NOT the reference point or the deciding factor in concluding whether a stock is cheap or not.

Jae Jun

Aggressive and Conservative Accounting Series

For previous articles in the series, click on the links below.

• Aggressive and Conservative Accounting Policies
• How to Detect Aggressive Revenue Recognition Policy
• FIFO LIFO Inventory Valuation Methods
• Straight Line and Accelerated Depreciation Methods
• Aggressive Accounting: Reserves, Allowances, Contingent Liabilities
• How Companies Misuse Capitalizing of Expenses

Introduction to Capitalizing Expenses

Companies expense costs related to the business which offsets revenue, but there are instances where companies will record costs as an asset on the balance sheet. This is what you call “capitalizing”. Note that this is completely different to capitalization/capital structure, which is how a firm finances its overall operations and growth by using different sources of funds.

To start, you need to group assets into two categories.

1. assets that are expected to produce a future benefit such as inventory, equipment and property
2. assets that are expected to be exchanged for another asset such as cash, receivables and investments

As an example for no.1, assume that a company has spent $10,000 for a two year insurance policy. At the time of the purchase, the entire amount represents a future benefit and would therefore be an asset. After one year passes the insurance policy would only have one year of insurance asset ($5,000) on the balance sheet with the other half ($5,000) now being classified as an expense.

By the end of the second year, the asset line will be zero and the expense line will show another $5,000 for the final year expense.

What you see is that if a company capitalizes an expense, the cash outflow is immediate but rather than offsetting the revenue immediately, only a partial amount is offset with the remaining being depreciated or amortized.

4 Ways in which Expenses can be Capitalized

Here are four ways to distinguish expenses from capital expenditures. In reality though, it can be difficult to distinguish between the two. (wikipedia)

1. Costs that produce a benefit that will last substantially beyond the end of the taxable year.
2. New assets that have a useful life substantially beyond one year.
3. Improvements that prolong the life of the property, restore property to a “like-new” condition, or add value to the property.
4. Adaptations that permit the property to be used for a new or different purpose.

There is a lot of gray in accounting and it is up to you as an investor to determine whether the capitalized costs are reasonable.

Can Marketing Costs be Capitalized?

Marketing expenses are normal operating expenses that produce short term benefits. Unless the company can produce evidence that a specific advertising will create long term benefits, assume that all marketing costs should be expensed instead of capitalized.

Marketing, advertising, solicitation costs are all the same thing. Don’t be fooled by the language that companies use in order to hide aggressive accounting.

3 Warnings Signs of Aggressively Capitalizing Expenses

1. Sudden improvements in profit margins with a large jump in certain assets
2. Big unexpected drops in FCF and cash flow from operations
3. Unexpected increases in capex that do not match company guidance and market conditions

Inappropriate Capitalizing of Expenses

Additional items you should watch for.

• Watch for changes in accounting policy as this is a big red flag. An accounting change is not growth. It will not recur.
• Watch for strange new asset line items on the balance sheet. If a new asset account suddenly appears and is growing rapidly, you have some information to dig up related to what this new asset is for.
• Capitalizing too much. Make sure the company does not capitalize more than it needs to. E.g. you wouldn’t want to see a company capitalized 100% of its R&D cost.
• Be wary of software development costs being capitalized. Early stage research and development should be expensed while later stage developments can be capitalized. Best to make sure it is in line with industry standards.
• Watch for different capitalization policies in the same industry.
• Watch for accelerated software capitalization. An accelerating rate of software capitalization is often a red flag that earnings benefited from keeping more costs on the balance sheet.

Companies are allowed to capitalize expenses but the decision comes down to what expenses should be capitalized. Most will remain within the boundary legitimacy while others will walk an aggressive tight line that leads to creative accounting and earnings manipulation.

Jae Jun

Aggressive and Conservative Accounting Series

For previous articles in the series, click on the links below.

• Aggressive and Conservative Accounting Policies
• How to Detect Aggressive Revenue Recognition Policy
• FIFO LIFO Inventory Valuation Methods
• Straight Line and Accelerated Depreciation Methods
• Aggressive Accounting: Reserves, Allowances, Contingent Liabilities
• How Companies Misuse Capitalizing of Expenses

Straight Line Depreciation Method

The simplest and most commonly used method of depreciation is the straight line method.

The straight line depreciation method takes the purchase or acquisition price, subtracts the salvage value and then divides it by the total estimated life in years.

For example, an equipment worth $1m with an estimated life of five years and salvage value of $100,000 would have the following depreciation schedule and asset value after each year as shown below.

Depreciation Expense = (Total Acquisition Cost – Salvage Value) / Useful Life

The characteristics of the straight line method is that the depreciation expense is constant so the valuation of the company is easier as you know how to adjust it if necessary. Plus, it is easy to predict.

Accelerated Depreciation Method

As the name suggests, this method allows companies to write off more of their assets in the earlier years and less in the later years. The biggest benefit of this method is the tax benefit. By writing off more assets against revenue, companies report lower income and thus pay less tax.

The common method of accelerated depreciation is called the double declining balance (DDB) method. This is where the depreciation expense doubles the straight line depreciation expense of the first year. The same percentage is then applied to the non depreciated amount in the subsequent years.

DDB in year 1 = 2/n * (Total Acquisition Cost – Accumulated Depreciation)

where n = number of years

DDB in year 2 and beyond = 2/n * (Asset Value on Balance Sheet)

Straight Line vs Accelerated Depreciation

Put these two side by side and you will be able to see the picture clearer.

In order to make the comparison as fair as possible, let’s assume company XYZ is just starting out as a business and they bought several new computers for their staff. The purchase value of the computers is $10,000.

Computers do not have a long useful life, but five years is realistic and adequate. Computers also deteriorate in value much quicker in the first year than the later years so an accelerated depreciation method is more than satisfactory. At then end of five years, computers are generally worthless so the salvage value will be $0.

As I mentioned earlier, one of the benefits to accelerated depreciation is the reduction of taxes, but another point of great benefit is if the equipment requires maintenance.

Accelerated depreciation will offset the increasing maintenance cost and essentially equalizes the combined charges of both maintenance and depreciation. The graph below is a simplified view of how the accelerated depreciation and maintenance cost works out to give a straight line total expense.

If the straight line method was used, the depreciation would be constant and the maintenance cost would increase which would increase the total expenses.

To see this side by side, we get the following table using the same assumptions as before but with the added maintenance expenses.

At the beginning of the life, the accelerated method obviously costs more but towards the later stages of the useful life, the expenses become much less.

In the first article I wrote comparing the aggressive and conservative methods, I labeled accelerated depreciation as the aggressive method. Reason being that by quickly reducing the depreciation expense, later on, the net income increases only due to the account method.

In the example with maintenance cost included, just after one year, the depreciation expense is already close to equal to the straight line method. By year three, the expense is much less compared to the straight line method, and so more revenue can be recognized without any improvements in business.

The straight line method on the other hand does not alter the performance of the business. It can be seen as a revenue smoothing method.

Depreciation Red Flags

That was the accounting part of it.

For the investing part of depreciation, it all depends on the type of company. If you are looking at a rapid tech company where assets lose most of the value within the first year, needs to be replaced regularly, and costs a lot to maintain, the accelerated method is the right choice.

This brings us to the big red flag related to depreciation.

If you come across a company where the depreciable life of the assets is extended or the useful life is much too long, watch out.

By depreciating assets too slowly, the company is using aggressive accounting. Sounds contradictory, but the result is that earnings are being manipulated by being artificially inflated.

This is true for amortization and writing off any other asset such as impaired assets and/or obsolete inventory.

When you go through the financial statements, quickly check what type of accounting method is used. Then compare it to a competitor and see whether it is inline with industry standards and suitable for the business model.

9 out of 10 times, you won’t find anything alarming, but that one time is what we are trying to protect ourselves from.

Written by

Jae Jun

Aggressive and Conservative Accounting Series

For previous articles in the series, click on the links below.

• Aggressive and Conservative Accounting Policies
• How to Detect Aggressive Revenue Recognition Policy
• FIFO LIFO Inventory Valuation Methods
• Straight Line and Accelerated Depreciation Methods
• Aggressive Accounting: Reserves, Allowances, Contingent Liabilities
• How Companies Misuse Capitalizing of Expenses

Inventory Valuation Methods in Accounting

Inventory can make up a large amount of the assets on the balance sheet and so knowing how to analyze the inventory, and the method used by management is crucial.

To put it in the most basic form, inventory is what you have in stock. If you expand on this definition to look at what is involved on the other side of the scale to get the ending inventory amount, the equation for inventory is

Beginning Inventory + Net Purchases – Cost of Goods Sold = Ending Inventory

In words, your beginning inventory along with your purchases and then subtracting what you have sold, results in ending inventory.

But this is where it gets tricky with GAAP rules. Depending on the inventory valuation  method used by the company, the COGS can vary considerably which ultimately affects the ending inventory.

Sadly, it is not as easy as counting what is left on the shelf at the end of the day to get the ending inventory value.

Three inventory valuation methods are used in the US.

1. Average cost method

2. First In First Out (FIFO) method

3. Last in First Out (LIFO) method

Average Cost Method

To put it real bluntly, the average cost method is rarely used. This method does not offer any real convenience or added accuracy.

The equation for average cost method is as follows.

Average Cost = (Total Quantity of Inventory Units) / (Total Quantity of Units)

where

Cost of Goods Sold = (Average Unit Cost) x (Number of Units Sold)

For example if 1,000 toys are produced on Monday at a cost of $1 and then on Tuesday another 1,000 toys are manufactured at a price of $1.05, the average cost method would value the inventory at $1.025 a piece.

FIFO Method

As mentioned previously on aggressive and conservative accounting policies, the FIFO method of valuing inventory is considered to be the aggressive method.

FIFO works like how you maintain your fridge at home. After you have bought some groceries, you tend to place what you just bought at the back of the fridge in order to finish off the older food before it spoils.

In other words, under FIFO, the oldest goods are sold first and the newest goods are sold last.

As a formula it would look like this

Unit Cost per batch = (Cost/Quantity) for each batch

where

Cost of Goods Sold = (Unit Cost x Quantity) for each batch

Using the toy example above, if 1,000 toys were then sold on Wednesday, the COGS would be $1 per unit. The remaining inventory on the balance sheet would then be worth $1.05 each.

LIFO Method

LIFO is the opposite of FIFO. Instead of the oldest inventory being considered as sold first, the newest product is sold first. While the factory analogy works for the FIFO, consider a bakery. By lunch or evening, the bread baked from the morning will not sell as well as the fresh ones from the afternoon batch.

This means that cost of the latest inventory now becomes the COGS with the cost of the oldest inventory being assigned to the inventory value on the balance sheet.

The equation is essentially the same as FIFO since both are calculated based on batches of unit sold.

Unit Cost per batch = (Cost/Quantity) for each batch

where

Cost of Goods Sold = (Unit Cost x Quantity) for each batch

Using the toy example, the 1,000 units sold on Wednesday would have a COGS of $1.05 per unit, with the remaining 1,000 toys being valued at $1 each.

How Inventory Valuation Affects Profits and Assets

As you can see from above, despite ending with the same 1,000 toys, FIFO assigns the inventory value to be $1,050 compared to the LIFO $1,000.

But another point is that the method of inventory valuation does not just affect the balance sheet. Gross profit also varies considerably. How?

Gross Profit = Sales – COGS

COGS differ under FIFO and LIFO, and if your COGS is low, then that means gross profit will increase.

The table below sums up how each of the three inventory valuations vary.

Things to Think About Regarding Inventory

Assuming that the world is in a vacuum, the table above illustrates that FIFO results in the biggest gross profit as well as the highest ending inventory value. This is a reason why FIFO is the method of choice for most companies.

Should a company change its accounting policies to switch from LIFO to FIFO, watch out, as management is more focused on trying to increase earnings instead of improving their operations.

If the toy manufacturer above was using the LIFO method and reported $350 in gross profit but then decided to change to FIFO resulting in a restated $500 gross profit, the accounting change alone has increased gross profit by 42.8%!

Also consider this. FIFO increases net income which would in turn increase taxes, but as I stated previously, most public companies are more concerned with showing an increase in earnings.

On the other hand, LIFO is not a good indicator of ending inventory as the remaining inventory could be extremely old and is likely to understate the inventory at today’s prices.

In the end, valuation is more art than science and you can probably see that after following this.

The best way to decide whether a company is being aggressive with inventory valuation is to use common sense and to check out the competitors in the industry. If everyone else is using the LIFO method and company X is the only one using FIFO, then you know you have found a red flag.

For such a simple component of the financial statement, there is quite a lot to think about.

You can also learn more about inventory analysis for investors by following the link.