Most investors do not realize that earnings, earnings per share and earnings growth are only accounting data (see Accounting 101) and should not be relied upon for making investment decisions. Accounting data was not designed for equity investors, but for debt investors. Accounting data predominates research because most research has come from investment banks, who care more about selling stock than informing investors. “[Accounting] Earnings, earnings per share and earnings growth are misleading measures of corporate performance.”(from page 66 in The Quest For Value by Bennett Stewart, Harper Collins 1991).
Though accounting rules may change from company to company or country to country, the basic economics of business are always the same. The basic economics of a business are: (1) how much real cash flow does the business generate relative to (2) how much capital has gone into the business over its life. All accounting data impacts either (1) the cash flows or (2) invested capital of businesses.
We think of the economic model (details below**) as the organic and natural analysis of business performance as it is free of accounting distortion, management bias and Wall Street salesmanship. Economic earnings play a key role in our stock ratings, which drive our mutual fund and ETF ratings.
Accounting data must be translated, using the Financial Footnotes, into economic earnings in order to understand the profitability and valuation relevant to equity investors (details on how to perform this translation are in Finance 101). Respected investors (e.g. Adam Smith, Warren Buffet and Ben Graham) have repeatedly emphasized that accounting results should not be used to value stocks. Economic earnings are what matter because they are:
- Based on the complete set of financial information available
- Standard for all companies
- A more accurate representation of the true underlying cash flows of the business
Therefore, the economic model based on all relevant financial information is required to asses the economic earnings of companies.
In addition to its intuitive logic, this fact is backed by scientific studies and loads of empirical evidence, the prior links are just a few samples. You can find much 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.
- Valuation: Measuring and Managing the Value of Companies by McKinsey and Co.
- Creating Shareholder Value by Alfred Rappaport
- The Quest For Value by Bennett Stewart
- Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports by Howard Schilit.
In addition to gaining expertise in accounting rules and economic theory, gathering all the relevant data to build a comprehensive economic model is quite time consuming and difficult. Our patented system and proprietary technology enabled us to build a Research Platform that, for the first time, allows investors to rely on a comprehensive economic model when making investment decisions. No longer must investors rely on the accounting data that Corporate America and Wall Street publish. Now, investors have, via New Constructs, an alternative source of unbiased, complete information on the economic profitability and valuation of companies.
**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 ever 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.