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Accounting 101

Thursday, May 13th, 2010

Most investors do not realize that earnings, earnings per share and earnings growth are only accounting data and should not be relied upon for making investment decisions because:

  1. Accounting rules were not designed for equity investors. They were designed for debt investors.
  2. Corporate America and Wall Street manipulate accounting rules to report the earnings they want to show.

Think of accounting data as just the words of the language of Finance (See Finance 101). Without proper structure, words have no meaning. With bad structure, words can be misleading. The same is true for accounting data, i.e. the data companies provide in annual reports, press releases etc. Companies rarely, if ever, speak finance to investors. They only provide accounting data b/c that is all the SEC requires – AND because accounting rules provide loopholes that enable companies to manipulate earnings, a well-known fact that has gone unaddressed for some time despite some empty saber-rattling. This 1999 Fortune article,”Lies, Damned Lies, and Managed Earnings“, makes this point perfectly. You can learn 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.

Wall Street likes using and referring investors to accounting data because they can make it say whatever they want. Wall Street firms care more about selling stock (which make money) than selling research (which does not make money). That’s right…research is a pure cost center for investment banks. Naturally, it is not in these firms’ best interests to write research that does not help them sell stock. Accounting data provides many tools for making the numbers look good enough to sell stock.

This fact is backed by the Global Research Settlement, which involved heavy fines for Wall Street. Despite those fines, the game has not changed.

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  1. varadha says:

    Terrific, yet simple analysis. I’ve always been a fan of ROIC as a measure of capital efficiency and believe that no size/growth outperformance can replace the quest for efficiency.

    Sort of like a big gas guzzling v8 that needs ever increasing gallons of fuel to keep its engine running

  2. David says:

    But Angie’s $90 per user acquisition cost is going to go away. That’s what their approach probably is. How would their outlook be if that $90 cost dropped down to a total cost of $3 per user?

  3. David:

    That would be great, but cost per user acquisition is not something that’s very easy for a company to fix. ANGI can slash their marketing budget to the bone, but then they would stop acquiring new members. They would probably lose members in fact, as their membership renewal rate is at ~75% and declining. If they cut marketing expense by ~95% as you seem to be suggesting, ANGI might be able to eke out 1 year of slight profits, but they would start shedding members and losing money very quickly. ANGI’s only hope is to keep its marketing budget high and hope it can reach the scale and brand awareness to be able to sustain its business while scaling back marketing costs enough to turn a profit. The fact that ANGI’s revenue growth is slowing down even as its marketing costs keep increasing makes it very unlikely it will achieve that goal.

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