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Economic Earnings Matter, GAAP Earnings Mislead

[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