Quality of Earnings Series
- Inventory & Accounts Receivables Analysis
- Earnings Made by Tax Rate Changes
Previously, I looked at analyzing the inventory and accounts receivables of a company which is a very simple yet highly effective method of detecting and predicting business performance. The method is not new but the extra work just isn’t performed by investors.
The good news is that I have created a stock spreadsheet version and I’ll be going through the methods described in the book ‘Quality of Earnings‘ to help detect warning signs and how much money a company is really making.
When this series is complete, and after some more thorough testing, the new updated financial statement spreadsheets will be released to existing spreadsheet buyers within their 1 year purchase timeframe as well as it being available for purchase.
Earnings Made by Tax Rate Changes
Wall Street is infatuated with EPS. If a company beats their estimates, the stock price is pushed up higher despite the fact that earnings is so easily manipulated by different accounting methods and hiding and/or delaying expenses.
Taxes also play a big role in the final EPS.
A company with a 40% tax rate one year, paying at 35% the next will create the illusion that growth has exceeded expectations, when in fact, the business did nothing but just get a tax break. The opposite is the same.
A company paying 35% in taxes and then 40% the next year will obviously report lower EPS and the consensus will be that the business is slowing down.
How to Calculate EPS Due to Tax Rate Change
Let’s use Boeing [[BA]] as an example.
1. Calculate the tax rate
To calculate the tax rate of a company, find the income tax expense on the income statement and divide by the Earnings Before Income Taxes (EBIT).
Boeing’s tax rate was 33.7%, 33.6% and 22.9% in 2007, 2008 and 2009 respectively.
2. Calculate the difference in tax rates
Just subtract the previous year tax to the next year tax rate.
3. Calculate the gain or loss due to difference in taxes
Use the difference in tax % compared to the last period and multiply it by the income before tax (EBIT) number.
In BA case for 2009, multiply 10.7% and $1,731m to determine how much of EBIT was due to a lower tax rate.
You can see that BA made $185m in EBIT due to taxes compared to $4.16m the year before. In 2007, Boeing’s tax rate increased by 2.7% which is why the % difference is negative and shows a loss due to difference in tax.
4. Divide by Shares Outstanding and Adjust the EPS
Divide the gain or loss due to tax change by the number of diluted shares.
You can now see that in 2009, of the full year diluted EPS, $0.26 was made up due to a reduction in taxes. So while the market may have seen this as a great recovery, the actual EPS was actually $1.58.
Multiply the current PE of 36 to $1.58 and the stock price should be at $56.
The above method can be applied to quarterly results for comparisons and basically any other line item including non-operating and non-recurring expenses.
Let’s wrap things up with a stock valuation summary of Boeing for those that hold the company.
BA Boeing Stock Summary