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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 Versus Accounting Earnings 2 comments
    Jul 17, 2012 3:34 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 NOPAT, Invested Cap­i­tal, WACC, ROIC, Free 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.

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Comments (2)
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  • Michael Clark
    , contributor
    Comments (12006) | Send Message
    Excellent post. Thank you for posting this.
    18 Jul 2012, 02:45 AM Reply Like
  • David Trainer
    , contributor
    Comments (1185) | Send Message
    Author’s reply » Mr. Clark,
    Thank you for your comment.
    We apply economic earnings diligence to all 3000 stocks we cover. There is no substitute, in my opinion, for real diligence, especially in this market. Easy money days are over, Time to roll up the sleeves and do some work.
    18 Jul 2012, 10:58 PM Reply Like
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