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Economic Versus Accounting Earnings

Proper diligence on any equity investment begins with earnings quality research. The first step in assessing earnings quality is measuring the true, economic earnings of a company. Economic earnings are very different from accounting earnings. They represent the true cash flows available to equity investors.

Accounting data was not designed for equity investors, but for debt investors. It is, by itself, not reliable for diligent investment decision-making.

“[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).

Much due diligence goes into studying disclosures and making numerous footnotes adjustments for proper derivation of economic earnings.

Formulas for Economic Earnings 

NOPATWACC*Invested Capital or

(ROICWACC)*Invested Capital = economic  earnings.

 

Key Concept Behind Economic Earnings:

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 financial statement data must be gathered to get an accurate measure of these basic drivers, which we call (1) the NOPAT and (2) Invested Capital.

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.

How To Use Accounting Data (Accounting 101)

Accounting data must be translated, through rigorous analysis of the footnotes and the MD&A, into economic earnings in order to understand the profitability and valuation relevant to equity investors. More details are in Finance 101.

Why Economic Earnings Are Better

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:

  1. Based on the complete set of financial information available
  2. Standard for all companies
  3. 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.

Numerous academic studies and loads of empirical evidence also also support the merits of economic earnings. 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.

  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.

Challenges In Deriving Economic Earnings

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:

  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.

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