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Asset-Earnings Equivalence

- Assets and earnings are equivalent. You can always restate an asset in terms of earnings. Andyou can always restate earnings in terms of an asset.

- You can always ask: what would this asset have to earn to be worth what the balance sheetsays it's worth? And you can always ask what someone would pay for a certain amount of

earnings. If they'd pay that amount that means they'd trade you cash today for those

earnings. And that means earnings can be thought of as being worth their (cash) sale value.

So earnings can always be thought of as if they were an asset.

- In physics, mass is a measure of the energy content of a body. In investing, value is ameasure of the earning content of a specific instance of capital.

- When I say a business will provide earnings of 40 cents a share pre-tax and a business isworth $4.00 a share Im really saying the same thing under special conditions (certain

interest rates). Intrinsic value is always relative. You can't value anything without a reference

point.

- There are two ways you can value an asset. You can value it in static terms by comparing it toother assets and valuing the asset against them. This uses other assets as your reference

point. Or you can value an asset by restating it as a flow of earnings and comparing that flow

to the price-to-free cash flow multiples of other businesses. This uses other cash flows as your

reference point. Really, youre just valuing the same thing capital in two different states.

- This is very obvious if you look at businesses over time. Or if you look at special situations. Ordeals of any kind.

- Basically, capital starts its life in a business with no earnings and a lot of potential. Then itgets put into all sorts of specific forms (real estate, inventory, receivables, intangibles). These

forms produce cash flows which throw off earnings that again build up as assets of some kind.

- The process is constantly cycling. Understanding this idea of asset-earnings equivalence willhelp you avoid errors caused by a one track mind.

- Take the example of a business that has $4.75 in cash per share and 40 cents in pre-taxearnings per share. Lets say the stock trades for $4 a share. Sounds fair, right? After all,

thats a P/E of 15 after-tax. Hardly cheap. Heres the problem with that logic. Lets say

businesses can be bought and sold for 10 times pre-tax earnings in our little investing

universe. At first from an earnings perspective it seems fair for a stock with 40 cents in

pre-tax earnings to trade for $4. But then we remember that assets and earnings are

equivalent. Obviously, if businesses really can be bought and sold for 10 times pre-tax

earnings, the company were looking at can just use its $4.75 in cash and buy another 47.5

cents of pre-tax earnings by going out and acquiring another business. But then the stock

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would have 87.5 cents of pre-tax earnings, which would make the stock worth $8.75 a share.

Not $4. Again, were just saying the same thing two ways. An asset worth $4.75 plus 40 cents

of pre-tax earnings equals $8.75 a share (if 10 times pre-tax earnings is a common multiple at

the moment).

- Capital on the balance sheet is just potential earnings on some future income statement. But and this is where we get into the softer side of the science of investing capital doesnt move

as freely from each of its special forms. Cash can turn into earnings very easily because it can

be converted into any other form of capital instantly.

- What about land? What about inventory? What about machinery? It depends.- Some of these assets are stuck capital. Machinery is often such a special and rigid form of

capital that its economically equivalent to a prepaid expense. I pay my website hosting fees

ahead of time and my website stays up for another month. Its a prepaid expense. The only

value I get out of this asset is the use I put the website to over the next 30 days. Likewise,machinery may be carried on the balance sheet at its original cost less accumulated

depreciation but its really just worth however much use you can get out of it. Thats not

true of cash. And its not true of assets like inventory and receivables if and only if they

can be turned into cash and removed from the business under certain circumstances.

- Often, when sales decline, inventory and receivables can be turned into cash and put to use innew lines of business.

- Thats part of the genius of Ben Graham. He focused on current assets. Under many but notall circumstances current assets that are underperforming in terms of earning production

can be turned into other forms of capital that will earn the returns generally available in the

economy. You can apply this test to any stock you buy for its assets. Just pick a rate of return

I suggest using the 30-year AAA corporate bond yield and apply it to the tangible invested

assets of the stock youre looking at.

- Remember to separate invested assets from assets that have accumulated on the balancesheet like cash that arent being used in the business. Then apply the long-term rate on

safe business bonds (today its 5%) to the invested capital inside the business. So, take a

business with $12 of invested tangible book value and multiply that $12 per share times 5%

to get 60 cents in pre-tax earnings potential. That gives you some idea of what the businessscapital could produce in earnings if put to use someplace else.

- Why does the earning potential of capital matter if the capital isnt earning up to that potentialnow? Two big parts of net-net investing are return of capital and transformation of capital.

Return of capital means turning more and more assets into cash and kicking them back to

shareholders. Transformation of capital means investing the same old capital in new and

different ways.

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- Intangible assets are often carried on balance sheets at amounts that have nothing to do withtheir economic value. So when I look at a business like FICO, I look at the earnings. They give

you a clearer idea of the value of the intangible assets the company controls. The same would

be true of a movie library. Its often easier to look at the cash the library throws off than the

amount the library is carried on the books at.