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David Trainer
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David is CEO of New Constructs (www.newconstructs.com), an independent research that specializes in unearthing key insights from the Financial Footnotes of Annual Reports. Having analyzed over 50,000 annual reports and their Financial Footnotes, New Constructs research regularly produces Hidden... More
My company:
New Constructs
My blog:
Hidden Gems and Red Flags
My book:
The Valuation Handbook
  • Economic Earnings Matter, GAAP Earnings Mislead 0 comments
    Nov 19, 2010 3:08 PM

    [Account­ing] Earn­ings, earn­ings per share and earn­ings growth are mis­lead­ing mea­sures of cor­po­rate performance.”(from page 66 in The Quest For Value by Ben­nett Stew­art, Harper Collins 1991). Most investors do not real­ize that earn­ings, earn­ings per share and earn­ings growth are only account­ing data (see Account­ing 101) and should not be relied upon for mak­ing invest­ment deci­sions. Account­ing data was not designed for equity investors, but for debt investors. Account­ing data pre­dom­i­nates research because most research has come from invest­ment banks, who care more about sell­ing stock than inform­ing investors.

    Though account­ing rules may change from com­pany to com­pany or coun­try to coun­try, the basic eco­nom­ics of busi­ness are always the same. The basic eco­nom­ics of a busi­ness are: (1) how much real cash flow does the busi­ness gen­er­ate rel­a­tive to (2) how much cap­i­tal has gone into the busi­ness over its life. All account­ing data impacts either the cash flows or invested cap­i­tal of businesses.

    We think of the eco­nomic model (details below**) as the organic and nat­ural analy­sis of busi­ness per­for­mance as it is free of account­ing dis­tor­tion, man­age­ment bias and Wall Street salesmanship.

    Account­ing data must be trans­lated, using the Finan­cial Foot­notes, into eco­nomic earn­ings in order to under­stand the prof­itabil­ity and val­u­a­tion rel­e­vant to equity investors (details on how to per­form this trans­la­tion are in Finance 101). Respected investors (e.g. Adam Smith, War­ren Buf­fet and Ben Gra­ham) have repeat­edly empha­sized that account­ing results should not be used to value stocks. Eco­nomic earn­ings are what mat­ter because they are:

    1. Based on the com­plete set of finan­cial infor­ma­tion available
    2. Stan­dard for all companies
    3. A more accu­rate rep­re­sen­ta­tion of the true under­ly­ing cash flows of the business

    There­fore, the eco­nomic model based on all rel­e­vant finan­cial infor­ma­tion is required to asses the eco­nomic earn­ings of companies.

    In addi­tion to its intu­itive logic, this fact is backed by sci­en­tific stud­ies and loads of empir­i­cal evi­dence, the prior links are just a few sam­ples. You can find much more by doing a quick inter­net search on account­ing loop­holes, account­ing tricks, etc. There are many excel­lent books, a few are listed below, that delve deeply into this topic as well.

    1. Val­u­a­tion: Mea­sur­ing and Man­ag­ing the Value of Com­pa­nies by McK­in­sey and Co.
    2. Cre­at­ing Share­holder Value by Alfred Rappaport
    3. The Quest For Value by Ben­nett Stewart
    4. Finan­cial Shenani­gans: How to Detect Account­ing Gim­micks & Fraud in Finan­cial Reports by Howard Schilit.

    In addi­tion to gain­ing exper­tise in account­ing rules and eco­nomic the­ory, gath­er­ing all the rel­e­vant data to build a com­pre­hen­sive eco­nomic model is quite time con­sum­ing and dif­fi­cult. Our patented sys­tem and pro­pri­etary tech­nol­ogy enabled us to build a Research Plat­form that, for the first time, allows investors to rely on a com­pre­hen­sive eco­nomic model when mak­ing invest­ment deci­sions. No longer must investors rely on the account­ing data that Cor­po­rate Amer­ica and Wall Street pub­lish. Now, investors have, via New Con­structs, an alter­na­tive source of unbi­ased, com­plete infor­ma­tion on the eco­nomic prof­itabil­ity and val­u­a­tion of companies.

    **Deriv­ing eco­nomic earn­ings from account­ing data is a dif­fi­cult and time-consuming task, pri­mar­ily because it requires ana­lyz­ing and extract­ing crit­i­cal infor­ma­tion from the Finan­cial Foot­notes. The Help Sec­tion of New Con­structs web­site walks you through ever step of the process. The first step is to cre­ate eco­nomic finan­cial state­ments, which are com­prised of:

    1. NOPAT (Net Oper­at­ing Profit After Tax)
    2. Invested Cap­i­tal cal­cu­la­tion and definition
    3. WACC (Weighted-Average Cost of Capital)

    Once you have your eco­nomic finan­cial state­ments, then you can derive the eco­nomic value dri­vers that we use to mea­sure the true, under­ly­ing prof­itabil­ity of companies.

    1. ROIC (ROIC stands for Return on Invested Capital)
    2. Eco­nomic Profit/earnings (note EVA is same as Eco­nomic Profit)
    3. Free Cash Flow
    4. NOPAT Mar­gin
    5. Invested Cap­i­tal Turns

    The Help Sec­tion of New Con­structs web­site shows how to cal­cu­late NOPATInvested Cap­i­talWACCROICFree Cash Flow, NOPAT Mar­gin, Invested Cap­i­tal Turns, EVA and Eco­nomic Profit/earnings and per­form rig­or­ous stock analy­sis your­self.

    The Method­ol­ogy Sec­tion of our Help Sec­tion gives you the inside-scoop on how to uncover the truth. For example, see

    1. List of Prob­lems with the Old Con­struct for equity research
    2. Learn the dif­fer­ences between account­ing earn­ings and eco­nomic earnings
    3. Learn the dan­gers of using P/E multiples
    4. Under­stand why the dis­tinc­tions between growth and value invest­ing styles are misleading
    5. Under­stand why cash is king and how to value stocks as War­ren Buffet does

    And much more on how to per­form rig­or­ous stock analy­sis your­self.

    Also, please see my post on Do It Your­self Guide To Finance for more infor­ma­tion on how to incor­po­rate our ana­lyt­i­cal tech­niques into your invest­ment strategy.

    Disclosure: No positions
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