Earnings Power Analysis

For stock research and screening, we use Fiscal.ai (use code “STABLEBREAD” to save 15%). It’s the most complete all-in-one research terminal we’ve found that’s accessible to the average retail investor.

For custom analysis and flexible valuation models, we use our Automated Stock Analysis Spreadsheet, powered by Wisesheets (the best spreadsheet add-on for stock data).

These are the two tools we use to analyze and value stocks more effectively and reach quicker, more informed investment decisions. Both have free versions if you want to try them out.

🌾 Welcome to StableBread’s Newsletter!

Look at this chart of Adobe’s (ADBE) EPS and y/y growth over the last 10 years:

While growth hasn’t been perfect, EPS is trending in the right direction (CAGR of 29.8%). Most investors would stop here, satisfied with what they see.

The reality, however, is that many companies report “healthy profits” despite actually burning cash and/or destroying shareholder value. The most infamous examples are Enron and WorldCom.

But the problem goes beyond fraud—every publicly traded company in the U.S. is required by the SEC to follow GAAP accounting rules. Unfortunately, this means reported numbers regularly mislead investors by omitting information about true cash generation and value creation.

So how can we separate companies with authentic earnings power from accounting mirages? Hewitt Heiserman's solution, in “It's Earnings That Count" (2005), was to build two alternate income statements that fix these omissions:

If you plot these two measures on a four-quadrant scatter chart, you derive Heiserman's Earnings Power Chart. Companies in the upper-right quadrant demonstrate both the ability to self-fund operations and create genuine economic value.

When you plot multiple years of results, you can track the "Earnings Power Staircase" pattern. Beyond the chart itself, Heiserman provides two supplementary ratios (debt repayment period and return on greenest dollar) that reveal whether a company's earnings power is sustainable and whether management is deploying capital effectively.

We’ll explain these concepts below and use Adobe as our main company example.

GAAP accounting overstates cash generation by ignoring two major cash drains that never appear as expenses:

The defensive income statement corrects these omissions by subtracting these hidden cash drains from operating income:

where:

A company with defensive profits can self-fund its growth without depending on external financing or diluting shareholders. One with defensive losses requires constant infusions of debt or equity just to maintain operations.

Adobe’s Defensive Income Statement

Here’s Adobe’s defensive income statement:

Adobe's operating income grew 12.3% annually (Nov '20 to Nov '24), but defensive EPS grew only 8.7% in the same period. Defensive EPS grew slower because Adobe invested ~$880M annually on average in fixed and working capital, which reduced defensive profits even as operating income climbed.

Bottom line: Adobe consistently generates defensive profits (~$5.9B in FY2024), confirming it can self-fund operations without external financing.

GAAP accounting distorts value creation through two mechanisms:

The enterprising income statement corrects these distortions by capitalizing intangibles and charging for equity capital:

where:

A company with enterprising profits creates value above investors' required returns. One with enterprising losses destroys value even if it reports accounting profits.

Adobe’s Enterprising Income Statement

Here’s Adobe’s enterprising income statement:

Adobe's operating income grew 12.3% annually (Nov '20 to Nov '24), but enterprising EPS grew only 6.3%. This slower growth reflects rising capital costs as enterprising interest increased from $1.0B to $1.6B while the capital base expanded.

For simplicity and conservatism, we capitalized only R&D spending and did not amortize advertising or marketing expenses, which likely understates Adobe's true intangible investments.

Bottom line: Adobe generates consistent enterprising profits (~$4.0B in FY2024), confirming ongoing value creation.

The Earnings Power Chart plots defensive profits vertically (y-axis) and enterprising profits horizontally (x-axis), creating four distinct quadrants:

True compounders display what Heiserman calls the "Earnings Power Staircase" pattern.

When a company's results each year plot higher and further right than the previous year, it creates a staircase visual that signals consistent improvement in both cash generation and value creation.

Adobe’s Position in the Earnings Power Chart

Here’s Adobe’s earnings power chart:

Adobe maintains positive defensive and enterprising profits across all periods, placing it in the Earnings Power Box.

Defensive EPS shows consistent growth from $9.39 to $13.12. Enterprising EPS peaked at $9.42 in Dec '21, declined to $8.68 by Dec '23, but rebounded to $8.94 in Nov '24.

Regardless, this pattern disqualifies Adobe as an Earnings Power Staircase company, which requires steady upward progression in both metrics.

Comparing Adobe’s EPS Numbers

Comparing diluted, defensive, and enterprising EPS reveals Adobe's true economics:

Defensive EPS usually sits highest because Adobe generates more cash than it invests.

Depreciation exceeds capex (averaging ~$310M annually), turning Adobe's asset base into a cash source. GAAP doesn't capture this, understating cash generation.

Enterprising EPS sits lowest because it charges Adobe for equity capital. The enterprising income statement deducts the cost of Adobe's capital base (debt, equity, intangibles) at ~6-8.5% WACC, while GAAP treats equity as free financing.

Now let’s examine the y/y growth chart:

Defensive and enterprising EPS both surged ~34% in Dec '21, declined through Dec '23, then rebounded modestly in Nov '24.

Diluted EPS (what most investors observe) moved opposite: declining 7.6% in Dec '21 (when cash generation exploded), then surging 17.1% in Dec '23 (when economic profits stagnated).

This inversion occurs because GAAP earnings respond to non-cash accounting adjustments (depreciation, amortization, stock comp) while defensive and enterprising profits track capital deployment and returns.

Heiserman’s earnings power ratios build on the defensive and enterprising income statements. These ratios assess financial strength and capital allocation effectiveness.

Debt repayment period measures how many years a company needs to repay all debt using its defensive profits. Unlike the debt-to-equity (D/E) ratio which relies on balance sheet values, this metric focuses on actual cash generation ability:

where:

Companies with debt repayment periods over 5 years carry excessive financial risk.

Adobe’s Debt Repayment Period

Here’s Adobe’s debt repayment period calculations:

Adobe's debt repayment period averaged 0.85 years over the last three periods, well below Heiserman's 5-year threshold for financial safety.

Return on greenest dollar measures the return earned on the most recent incremental investment in the business. Unlike most return on capital metrics that use total capital, this focuses on the “greenest” (newest) dollar invested:

where:

Successful companies generate returns well above their cost of capital. Low, negative, or erratic returns signal poor capital allocation decisions.

Adobe’s Return on Greenest Dollar

Here’s Adobe’s return on greenest dollar calculations:

Adobe's return on greenest dollar fluctuates significantly, suggesting inconsistent capital allocation.

However, the Nov '24 return of 14.7% exceeds Adobe's 8.3% WACC, indicating the company still creates value on incremental capital despite the decline from earlier periods.

According to Heiserman, ideal investments demonstrate three characteristics:

Adobe passes two of Heiserman's three tests. It sits in the Earnings Power Box and generates defensive profits that could repay all debt in roughly one year.

However, it fails the staircase requirement as enterprising EPS peaked at $9.42 in Dec '21 and has not recovered to that level.

While some companies outside the Earnings Power Box successfully turn around and others within it face sudden disruption, Heiserman's framework should help you evaluate the authentic earnings power of any publicly traded company.

The ideal time to buy is when a company enters the Earnings Power Box and you expect it to remain there with improving metrics. The ideal time to sell is when it drifts toward the "cash without value" quadrant or worse.