Economic Vs. Accounting Earnings
Proper diligence on any equity investment begins with earnings quality research. The first step in assessing earnings quality is measuring the true, economic earnings of a company. Economic earnings are very different from accounting earnings. They represent the true cash flows available to equity investors.
Accounting data was not designed for equity investors, but for debt investors. It is, by itself, not reliable for diligent investment decision-making.
"[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).
Much due diligence goes into studying disclosures and making numerous footnotes adjustments for proper derivation of economic earnings.
Formulas for Economic Earnings
NOPAT - WACC*Invested Capital = economic earnings
(ROIC - WACC)*Invested Capital = economic earnings
Key Concept Behind Economic Earnings:
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 financial statement data must be gathered to get an accurate measure of these basic drivers, which we call (1) the NOPAT and (2) Invested Capital.
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. Economic earnings play a key role in our stock ratings, which drive our mutual fund and ETF ratings.
How To Use Accounting Data
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.
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 and the Management Discussion & Analysis section of 10-Ks (MD&A).
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