Chapter 9
How to Determine an Equitable Equity Number
The last several pages were pretty heavy in one way, but on the other hand, the concept is very much just plain common sense. Look at it this way: You are just one step away from being able to develop a portfolio that will outperform most of those professional money managers out there in Investment Land: just one step away. Once you are finished with this book, the adoption of Clean Surplus into your stock portfolio will indeed seem second nature. And as I said to myself when I first learned the system, “This is so easy, why didn’t I think of this method myself?”
Let’s Review Just a Bit
Previously we learned that we could not use earnings as a comparable number between different companies. This was because the earnings number becomes distorted as a comparable number due to unique, non-recurring items on the income statement (Figure 9.1). These non-recurring items certainly must be accounted for, but in no way do they allow for the predictability that the investment community so dearly seeks.
Figure 9.1 Earnings and Book Value Distorted by Non-Recurring Items on Income Statement
We also learned that if the earnings number is distorted as a comparable number due to the non-recurring items, then book value (owners’ equity) also becomes distorted as a comparable number between companies. The earnings number from the income statement directly affects book value on the balance sheet because retained earnings (earnings minus dividends) is the tie-in between the two statements. Thus, one distortion keeps on distorting. Or, one bad apple spoils all the others.
Bottom line: Neither traditional accounting earnings nor traditional accounting book value (owners’ equity) can be used as comparable numbers. Thus, the traditional return on equity (ROE) ratio, which consists of both traditional accounting earnings and traditional accounting book value, cannot be used as a comparison ratio. Eat your heart out, Wall Street.
We’ve already solved the problem of the return portion of the ROE ratio. Rather than using earnings, we use net income as our return number (Figure 9.2). Net income is configured the same among all companies and is thus a comparable number.
Figure 9.2 Net Income Used as Return Number
However, we still have a problem with book value (owners’ equity), which we are about to solve right now. Just remember that net income does not equal earnings when there are non-recurring items in the equation. Somehow we must standardize the book value (owners’ equity) number, so we can develop a Clean Surplus ROE that allows us to compare one company to another.
Our New Return on Equity Equation
In order to find a comparable book value or owners’ equity, we must develop a book value (owners’ equity) in the same manner as we did with our bank accounts. In other words, we must develop a Clean Surplus book value (owners’ equity).
The return (earnings) on equity (book value) from the accounting statements cannot be used as a good comparison ratio.
Between 1895 and 1937, there was concern in accounting circles of the inability of accounting statements to predict the operating efficiency and thus the future value of a company.
The discussion centered on how the accounting numbers should show what investors needed to know about a company and at the same time allow for some sort of predictive capability.
The result was a surplus accounting statement showing earnings before abnormal charges or non-recurring items (extraordinary write-offs and future liabilities), which is, of course, net income. Thus, in Clean Surplus Accounting, net income becomes the “return” number for the ROE calculation.
Book value or owners’ equity is not as easy. Surplus accounting, which was later called Clean Surplus Accounting, calculates its own owners’ equity true to the definition of owners’ equity. Remember, owners’ equity is the common stock issuance plus all retained earnings.
But Clean Surplus distinctly says that the only addition to the retained earnings account on the balance sheet should be net income (minus dividends) from the income statement.
We can now begin to understand and use the true definition of owners’ equity: the common stock issuance plus all retained earnings. According to Clean Surplus, these retained earnings can only come from net income (minus dividends).
Let’s examine two separate bank accounts (oh no, not again!), each beginning with $100 (Table 9.1). Let’s also assume all interest (net income) is reinvested back into both accounts.
Table 9.1 Bank A and Bank B—Beginning with $100
| Bank A | Bank B | |||||
| Year | Equity | Interest | ROE | Equity | Interest | ROE |
| 5 | $146.00 | $14.60 | 10.00% | $142.45 | $11.40 | 8.00% |
| 4 | $133.00 | $13.30 | 10.00% | $131.29 | $11.00 | 8.50% |
| 3 | $121.00 | $12.10 | 10.00% | $120.45 | $10.85 | 9.00% |
| 2 | $110.00 | $11.00 | 10.00% | $110.00 | $10.45 | 9.50% |
| 1 | $100.00 | $10.00 | 10.00% | $100.00 | $10.00 | 10.00% |
Owners’ equity is defined as the amount of money the owners put into the bank account plus all the retained interest. Don’t forget, the interest (net income) belongs to the owners. Since the interest is retained in the bank account, it is called “retained” interest (retained earnings).
This bank example shows how simply Clean Surplus works. Owners’ equity of today equals owners’ equity of last period plus the retained profits at the end of the last period.
In Clean Surplus Accounting, retained profits is net income (minus dividends). Or, how much money with which we began the year plus how much we earned (and retained) gives us next year’s beginning balance.
Yes, Clean Surplus Accounting is this simple because it is clean. It is clean because we do not include in our calculations any future liabilities or extraordinary write-offs or any non-recurring items, which do not lend themselves to predictability.
We actually use Clean Surplus to figure the yearly returns on our bank account and our stock accounts. It’s a wonder analysts don’t use it to figure the return on a company’s assets. Of course, those who read this book will use it. And after you finish this book, you will use it forever.
Looking to the bank account examples in Table 9.1, we can see that the ROE for Bank A is a constant 10 percent. However, Bank B, because of some unknown reason, shows an ever-decreasing ROE.
Note: We don’t care what the reason is that the ROE of Bank B is decreasing. All we want to know as investors is which bank is the better bank relative to operating efficiency? Clean Surplus ROE is a bottom- line number that tells us which company is being more efficient about its operations. The Clean Surplus ROE tells us which companies should be in our portfolio and which companies should be in somebody else’s portfolio.
The question for us to answer is very simple: All else being equal, which bank would you rather put your money in?
And the second question is equally simple: Why can’t we use the bank account method in the same manner with individual companies as well as our bank accounts?
We can use the bank account example and we will because Clean Surplus Accounting allows us to do so. And you will see that Clean Surplus Accounting is the concept that makes us different from the rest of the investment world.
What Does Warren Buffett Say about All This?
What does Warren Buffett say about the shortcomings of accounting book value? He simply says that accounting book value is meaningless as an indicator of a firm’s intrinsic value.
I don’t know about you, but Buffett pretty much says in just one sentence what I’ve been trying to get across to you for the past nine chapters. And I’ll spend several more chapters showing you how Clean Surplus works in the real world.