Economic Versus Accounting Earnings

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:

  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.

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.

  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.

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 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.

This entry was written by David Trainer, posted on August 5, 2010 at 8:35 am, filed under Decoding Propaganda, Investing 101 and tagged , , , , , , , , , , , . Bookmark the permalink. Follow any comments here with the RSS feed for this post. Post a comment or leave a trackback: Trackback URL.

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  1. By New Constructs Receives Patent on Research System – Hidden Gems and Red Flags in the Stock Market on August 5, 2010 at 8:37 am

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  6. By Black Liquor Tax Credit Comes Back To Burn Paper Companies - Great Speculations - Buys, holds, and hopes - Forbes on October 29, 2010 at 1:04 pm

    [...] of distortions that mask true economic earnings—-the AFMC Windfall is just another example of why accounting earnings were not designed for equity analysis. Two companies, Kapstone Paper and Packaging [...]

  7. By Black Liquor Tax Credit Comes Back To Burn Paper Companies | Forxtrad's Blog on October 31, 2010 at 10:54 am

    [...] distortions that mask true economic earnings�-the AFMC Windfall is just another example of why accounting earnings were not designed for equity analysis. Two companies, Kapstone Paper and Packaging [...]

  8. By Wall Street’s Secret Plans To Continue Raiding Capital Markets - Great Speculations - Buys, holds, and hopes - Forbes on November 1, 2010 at 12:48 pm

    [...] because they are stupid, they make them, most of the time, because they are misinformed. They are misinformed by the reported accounting results on profitability. Time after time, we see companies (often with the help of Wall Street) [...]

  9. By Black Liquor Tax Credit Clouds Paper Companies’ Earnings - Great Speculations - Buys, holds, and hopes - Forbes on November 8, 2010 at 10:42 am

    [...] of distortions that mask true economic earnings—-the AFMC windfall is just another example of why accounting earnings were not designed for equity [...]

  10. By Clean Up With The Very Cheap Colgate-Palmolive - Great Speculations - Buys, holds, and hopes - Forbes on November 9, 2010 at 10:10 am

    [...] all of our Most Attrac­tive Stocks the com­pany has (1) high and ris­ing eco­nomic prof­its (as dis­tinct from account­ing prof­its) and (2) a cheap val­u­a­tion. As shown in our free report on CL, the company’s return on [...]

  11. By Colgate-Palmolive: Rising Profits, Cheap Valuation | Smart Stocks Investing on November 10, 2010 at 8:48 am

    [...] Attrac­tive Stocks, the com­pany has (1) high and ris­ing eco­nomic prof­its (as dis­tinct from account­ing prof­its) and (2) a cheap val­u­a­tion. As shown in our free report on CL, the company’s [...]

  12. By The Travelers Gets Little Love But It’s A Money Machine - Great Speculations - Buys, holds, and hopes - Forbes on November 23, 2010 at 10:59 am

    [...] all of our most attrac­tive stocks the com­pany has (1) high and ris­ing eco­nomic prof­its (as dis­tinct from account­ing prof­its) and (2) a cheap val­u­a­tion. As shown in our free report on TRV, the company’s return on [...]

  13. By The Leak on WikiLeaks – Regulators Should’ve Known About CDS Risks That Led to Financial Fallout – Hidden Gems and Red Flags in the Stock Market on December 2, 2010 at 11:20 am

    [...] required to ana­lyze Finan­cial State­ments and the Finan­cial Foot­notes to deter­mine the true eco­nomic earn­ings of com­pa­nies. But the ben­e­fits can [...]

  14. By Have No Fear Of Heights, Plug Into Analog Devices - Great Speculations - Buys, holds, and hopes - Forbes on December 7, 2010 at 11:36 am

    [...] stocks, boasts a 54% ROIC. The com­pany also has high and ris­ing eco­nomic prof­its (as dis­tinct from account­ing prof­its) and  a cheap [...]

  15. By Accenture Is Cheap And Not Due To A Flash Crash This Time - Great Speculations - Buys, holds, and hopes - Forbes on January 6, 2011 at 11:20 am

    [...] one of  December’s Most Attrac­tive Stocks. It has (1) high and ris­ing eco­nomic prof­its (as dis­tinct from account­ing prof­its) and (2) a cheap [...]

  16. By Don’t Just Watch University Of Phoenix Rise From Ashes Of Four-Year Lows - Great Speculations - Buys, holds, and hopes - Forbes on January 19, 2011 at 4:39 pm

    [...] details on what causes the dif­fer­ence between eco­nomic ver­sus account­ing prof­its, see Appen­dix 3 on page 10 of our report on APOL. See Appen­dix 4 to learn how APOL increased [...]

  17. By Hedge Against A Market Sell-Off; Sell NYSE Euronext (NYX) – Hidden Gems and Red Flags in the Stock Market on February 8, 2011 at 9:13 am

    [...] earn­ings”: NYX reported a $957mm increase in GAAP earn­ings while our model shows eco­nomic earn­ings declined by $641mm (a dif­fer­ence of $1,599mm or 34% of 2009 rev­enues dur­ing the last [...]

  18. By Shorting The NYSE A Good Hedge Against Market Selloff - Great Speculations - Buys, holds, and hopes - Forbes on February 11, 2011 at 8:36 am

    [...] earn­ings”: NYX reported a $957 million increase in GAAP earn­ings while our model shows eco­nomic earn­ings declined by $641 million (a dif­fer­ence of $1.6 billion or 34% of 2009 revenues during the last [...]

  19. By Big Writedowns And Larry Ellison Are Enough Reasons To Sell Ariba - Great Speculations - Buys, holds, and hopes - Forbes on February 25, 2011 at 10:13 am

    [...] Internet bubble companies to survive and reach profitability, on a GAAP accounting basis at least. Looking beyond the reported accounting results, however, we see that ARBA is not quite as profitable a company as it seems and that its valuation [...]

  20. By Body Slam The Market, Buy World Wrestling Entertainment - Great Speculations - Buys, holds, and hopes - Forbes on March 3, 2011 at 9:26 am

    [...] details on what causes the dif­fer­ence between eco­nomic ver­sus account­ing prof­its during the last five fiscal years, see Appen­dix 3 on page 10 of our report on WWE. See Appen­dix [...]

  21. By Bleeding Loan Loss Reserves Artificially Boosts: Sell Principal Financial Group, Inc. (PFG) – Hidden Gems and Red Flags in the Stock Market on March 8, 2011 at 9:48 am

    [...] Look­ing beyond the reported account­ing results reveals that PFG is not quite as prof­itable a com­pany as it seems, and its val­u­a­tion has out-grown its prof­its by a wide mar­gin – the required com­bi­na­tion of fac­tors for mak­ing March’s list of most dan­ger­ous stocks. [...]

  22. By Fun With Loan Loss Reserves, Or Why Not To Buy Principal Financial - Great Speculations - Buys, holds, and hopes - Forbes on March 8, 2011 at 3:13 pm

    [...] Looking beyond the reported accounting results reveals that PFG is not quite as profitable a company as it seems, and its valuation has out-grown its profits by a wide margin, the required combination of factors for making my March list of most dan­ger­ous stocks. [...]

  23. By Don’t Call It A Comeback: Buy Intel Corp (INTC) – Hidden Gems and Red Flags in the Stock Market on March 15, 2011 at 8:26 am

    [...] back to 1998, shows 2010 as the most prof­itable year ever in terms of account­ing earn­ings, eco­nomic earn­ings, and free cash flow. Return on invested cap­i­tal (ROIC), which more than dou­bled to 31% in [...]

  24. By Back Up The Truck And Load Up With Intel - Great Speculations - Buys, holds, and hopes - Forbes on March 15, 2011 at 11:42 am

    [...] back to 1998, shows 2010 as the most profitable year ever in terms of accounting earnings, economic earnings, and free cash flow. Return on invested capital (ROIC), which more than doubled to 31% in 2010, is [...]

  25. By Back Up The Truck And Load Up With Intel | Intel | Computer World on March 16, 2011 at 2:06 am

    [...] back to 1998, shows 2010 as the most profitable year ever in terms of accounting earnings, economic earnings, and free cash flow. Return on invested capital (ROIC), which more than doubled to 31% in 2010, is [...]

  26. By VirnetX Value Looks To Be In Domain Of The Insecure - Great Speculations - Buys, holds, and hopes - Forbes on April 12, 2011 at 10:08 am

    [...] $41 million or $0.84 per share. Removing the patent infringement settlement gain and looking at the economic earnings, we find that VHC’s profits declined by $35 million to -$47 [...]

  27. By Eli Lilly: An Attractive Stock Safe Enough to Take Home to Mom | buy stock picks on April 19, 2011 at 4:18 pm

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  28. By Eli Lilly Is Good Medicine For A Sick Portfolio - Great Speculations - Buys, holds, and hopes - Forbes on April 20, 2011 at 8:31 am

    [...] our model shows Eli Lilly’s profits are strong and rising as the company’s 2010 economic earnings rose over 10% to $3.74 billion and reached an all-time high. Economic earnings have grown every [...]

  29. By New Special Red Flag Report on Off-Balance Sheet Debt – Hidden Gems and Red Flags in the Stock Market on June 20, 2011 at 12:52 pm

    [...] Expla­na­tion of exactly how the off-balance sheet debt from oper­at­ing leases affect eco­nomic earn­ings. [...]

  30. By How to make money picking stocks – Hidden Gems and Red Flags in the Stock Market on June 20, 2011 at 1:50 pm

    [...] Mea­sure the true prof­itabil­ity of the busi­ness, which requires trans­lat­ing account­ing data into eco­nomic earn­ings, to under­stand its his­tor­i­cal [...]

  31. By Nucor Corporation (NUE) — Dangerous Risk/Reward Rating for Ask Matt Readers – Hidden Gems and Red Flags in the Stock Market on July 7, 2011 at 4:21 pm

    [...] details on our analy­sis of the eco­nomic earn­ings of NUE and our stock rat­ing sys­tem, see the free report avail­able at the link above as well [...]

  32. By “Most Attractive Stocks” Earn Top-Ranking Again – Hidden Gems and Red Flags in the Stock Market on August 1, 2011 at 11:48 am

    [...] of the highly rig­or­ous work we do for every stock and fund we cover. Focus­ing on revers­ing account­ing dis­tor­tions and dis­counted cash flow analy­sis after incor­po­rat­ing key data from the Finan­cial [...]

  33. By Should Directors Ignore Those One-Time Items? – Hidden Gems and Red Flags in the Stock Market on September 7, 2011 at 3:20 pm

    [...] need to focus on eco­nomic earn­ings that are adjusted for and free of accou­t­ing dis­tor­tion. It takes a lot of work, but it is [...]

  34. By Sell Baker Hughes Before The Stock Goes Up In Fumes – Hidden Gems and Red Flags in the Stock Market on September 13, 2011 at 11:36 am

    [...] impact of an acqui­si­tion on a company’s account­ing earn­ings is not indica­tive of its eco­nomic value to [...]

  35. By Sell Baker Hughes Before The Stock Goes Up In Fumes | buy stock picks on September 14, 2011 at 7:08 am

    [...] impact of an acqui­si­tion on a company’s account­ing earn­ings is not indica­tive of its eco­nomic value to [...]

  36. By Tech ETFs In Focus: The Holdings Are The Key | ETF Database on October 7, 2011 at 6:47 am

    [...] a given category, investors need a predictive rating for ETFs based on analysis of the underlying quality of earnings and valuation of the stocks in each [...]

  37. By Danger Zone 1/14/2013: Fulton Financial Corp. (FULT) – Hidden Gems and Red Flags in the Stock Market on January 14, 2013 at 7:34 pm

    [...] accounting trick has driven EPS up while actual economic earnings are declining, and investors appear to be falling for [...]

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