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Joe, Kevin –

First, thanks for buying IETC. I hope the book helps you get a lot richer.

Second, if you or any other guests of this site want a copy of the presentation I gave at the Complete Growth Investor Las Vegas last October, please send me an e-mail at Hewitt.Heiserman@EarningsPower.com.

Third, before we jump into the mechanics of the enterprising income statement, let's take a moment to recall the question we are trying to answer: Is management creating value? We are not trying to determine if the company can pay its bills as it grows—that's the defensive income statement's job; and we are not trying to determine if the stock's price is compelling—that's valuation.

Okay, management creates value when they earn a return on capital that is greater than its cost. The two main sources of capital are debt and equity. As you know, you have book debt and book equity—these amounts are what you find on the balance sheet; and then you have market debt and market equity—this is what debt and stock trade for on the open market. Book values and markets values may or may not be the same.

When estimating capital, I use the book value of debt and equity. Book reflects how much money management has at its disposal to finance the asset side of the balance sheet, which in turn creates revenue and, hopefully, net income. Market values reflects the market's assessment of a variety of factors; e.g., does the company has defensive profits, is it creating value, are industry conditions attractive, are stock market conditions attractive, etc. etc. Management has little control over most of these factors, so it is not fair to judge them on events and conditions that are outside of their control, in my view.

Let me give an example. At year-end 2007, American Eagle had $838 million of operating leases, $110 million of senior liabilities, and $1.4 billion of book equity. Add these three sources of cash (there was no debt), subtract excess cash, and you get $1.9 billion. The market value of AEO's equity was $7.4 billion.

Now, a question. If you turned to the asset side of AEO's balance sheet, do you think operating assets are $1.9 billion? Or, do you think operating assets are $8.3 billion ($7.4 billion + $838 million + $110 million)?

If you said $1.9 billion, you are correct. Working capital assets include $(137) million of working capital [remember, we love negative WC—it's like having a job where you get paid today for work you will do in two weeks], $482 million of plant, property, and equipment, $838 million of capitalized leases, $453 million of operating cash [I discussed operating cash in an earlier post...maybe 12-18 months ago], and other assets of $298 million. Add it all up and you get $1.9 billion--the same $1.9 billion that we calculated from the right/bottom side of the balance sheet. Point is, management had $1.9 billion of assets to finance its income statement, not $8.3 billion.

To sum up, I use book values to estimate capital and the cost of capital. The reason is because we want to test whether management is earning a profit on the capital at their disposal. Market values, in contrast, overstate the amount of working capital and fixed capital that a firm employes to generate revenue and income.

Excellent question. If I did not answer your question adequately, please let me know.


Hewitt


Hewitt
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