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Finance 101

Thursday, May 13th, 2010

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:

  1. Gather all the accounting data PLUS data from the Notes to the Financial Statements
  2. Leverage expertise in both accounting and economics to understand the data and its impact on profitability and valuation
  3. 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:

  1. NOPAT (Net Oper­at­ing Profit After Tax)
  2. Invested Cap­i­tal cal­cu­la­tion and definition
  3. 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.

  1. ROIC (ROIC stands for Return on Invested Capital)
  2. Eco­nomic Profit/earnings (note EVA is same as Eco­nomic Profit)
  3. Free Cash Flow
  4. NOPAT Mar­gin
  5. Invested Cap­i­tal Turns

The Help Section of New Constructs website shows how to cal­cu­late NOPATInvested Cap­i­talWACCROICFree 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

  1. List of Prob­lems with the Old Con­struct for equity research
  2. Learn the dif­fer­ences between account­ing earn­ings and eco­nomic earnings
  3. Learn the dan­gers of using P/E multiples
  4. Under­stand why the dis­tinc­tions between growth and value invest­ing styles are misleading
  5. 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.

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3 Comments

  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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