Economic earnings represent the true earnings for shareholders and are very different from accounting earnings. GAAP accounting data was not originally designed for equity investors, but for debt investors.
To derive economic earnings, 30+ adjustments must be made to accounting earnings. These adjustments remove items hidden in the footnotes and MD&A of annual filings and close loopholes within GAAP accounting.
The formulae for economic earnings are in Figure 1.
Figure 1: How To Calculate Economic Earnings
NOPAT – WACC * Invested Capital
(ROIC – WACC) * Invested Capital
Sources: New Constructs, LLC and company filings
Economic earnings are better than accounting earnings because
- They are based on the complete set of financial information available
- They are normalized for all companies
- They are a more accurate representation of the true underlying cash flows of business.
If a company is not generating positive economic earnings, it is not creating shareholder value. Figure 2 shows which companies are creating and destroying the most value.
Figure 2: Companies With Highest/Lowest Economic Earnings
Sources: New Constructs, LLC and company filings.
Out of 3000+ companies, Apple (AAPL) earns the largest economic earnings at over $51 billion. See Apple’s historical economic earnings dating back to 1998 here. Apple has earned positive economic earnings every year dating back to 2004. Gilead Sciences (GILD), Microsoft Corporation (MSFT), China Mobile Limited (CHL), and Alphabet (GOOGL) each generate some of the highest economic earnings of all companies under coverage. In order to be as transparent as possible, we provide a reconciliation of GAAP net income to economic earnings in each of our company models. Investors only stand to benefit from increased transparency, which is why our calculations are made available in each company model. The reconciliation of Gilead’s GAAP net income to economic earnings can be found here.
Entergy Corporation (ETR) generates the lowest, or most negative economic earnings of all companies under coverage. See Entergy’s historical economic earnings dating back to 1998 in our model here. As can be seen in our model, Entergy has failed to generate positive economic earnings in any year of our model. The company has consistently increased its invested capital while not generating a subsequent increase in profits, thereby destroying shareholder value in the process. See the reconciliation of GAAP net income to economic earnings here. Citigroup (C), Deutsche Bank (DB), Lloyds Banking Group (LYG), and Chevron Corporation (CVX) round out the top five companies with the lowest economic earnings.
Our models and calculations are 100% transparent because we want our clients to know how much work we do to ensure we give them the best earnings quality and valuation models in the business.
Want to apply these concepts and more?
How To Use Accounting Data (Accounting 101)
Accounting data must be translated, through rigorous analysis of the footnotes and the MD&A, into economic earnings in order to understand the profitability and valuation relevant to equity investors. More details are in Finance 101.
Why Economic Earnings Are Better
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:
- Based on the complete set of financial information available
- Standard for all companies
- 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.
Numerous academic studies and loads of empirical evidence also also support the merits of economic earnings. 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.
- Valuation: Measuring and Managing the Value of Companies by McKinsey and Co.
- Creating Shareholder Value by Alfred Rappaport
- The Quest For Value by Bennett Stewart
- Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports by Howard Schilit.
Challenges In Deriving Economic Earnings
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:
- NOPAT (Net Operating Profit After Tax)
- Invested Capital calculation and definition
- 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.
- ROIC (ROIC stands for Return on Invested Capital)
- Economic Profit/earnings (note EVA is same as Economic Profit)
- Free Cash Flow
- NOPAT Margin
- Invested Capital Turns
See our webinar on importance of ROIC and how to calculate it.
Here is our report on “ROIC: The Paradigm For Linking Corporate Performance to Valuation.“