Finance is the process for making accounting data useful.
Incomplete accounting data not only has low utility but also can be misleading. The only way to have a complete set of accounting data is to gather many critical data points from the Notes to the Financial Statements.
Per Accounting 101: accounting data (i.e. the financial statements: income statement, cash flow statement and balance sheet) by itself is not useful. One must analyze and gather data from the Notes to the Financial Statements in order to convert accounting data into economic earnings. Note that Harvard Business School & MIT Sloan prove the importance of footnotes data to accurately measuring earnings in The Journal Of Financial Economics.
Think of accounting data as the words used in the language of Finance. Just as with any language, words can be arranged to convey almost any meaning. Arranging accounting data to tell the truth about profitability requires a substantial amount of work to:
- Gather all the accounting data PLUS data from the Notes to the Financial Statements
- Leverage expertise in both accounting and economics to understand the data and its impact on profitability and valuation
- Build models that analyze and interpret all relevant data correctly
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 first step is to create economic financial statements, which are comprised of:
- NOPAT (Net Operating Profit After Tax)
- Average Invested Capital
- 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 Earnings (same as "EVA")
- Free Cash Flow
- NOPAT Margin
- Invested Capital Turns
The Metrics section of our 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 Education section provides a wide variety of materials to give you the inside-scoop on how to uncover the truth. For example, see
- Accounting Fixes: details all the GAAP loopholes
- Value Investing 2.0: how we technology to do it better
- Learn the dangers of using P/E and other multiples
- See why the distinctions between growth and value investing styles are misleading
- See why cash is king and how to value stocks as Warren Buffet does
- See all of our Ratings Methodologies
- See how all of our financial models are 100% transparent and auditable.
And much more on how to perform rigorous stock analysis yourself.