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 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

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.