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.
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 Help Section of New Constructs website walks you through every 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
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
- List of Problems with the Old Construct for equity research
- Learn the differences between accounting earnings and economic earnings
- Learn the dangers of using P/E multiples
- Understand why the distinctions between growth and value investing styles are misleading
- 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.