Economic Versus Accounting Earnings

“[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). 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.

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 the cash flows or 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.

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.

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.

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.

36 Trackbacks

  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

    […] Eco­nomic Ver­sus Account­ing Earnings […]

  2. By Stock Pick of the Week: Buy International Business Machines (IBM) – Hidden Gems and Red Flags in the Stock Market on August 17, 2010 at 8:43 am

    […] Eco­nomic Ver­sus Account­ing Earnings […]

  3. By Sandridge Energy (SD)- Free Report for Ask Matt Readers– Dangerous Rating – Hidden Gems and Red Flags in the Stock Market on August 19, 2010 at 2:16 pm

    […] Stock Pick of the Week Inter­na­tional Busi­ness Machines (IBM) — Very Attrac­tive Rating […]

  4. By Stock Pick of the Week: Sell/Short FedEx Corp (FDX) – Hidden Gems and Red Flags in the Stock Market on August 24, 2010 at 8:30 am

    […] Eco­nomic Ver­sus Account­ing Earnings […]

  5. By Pessimism Is Way Too Think For Insanely Cheap Bristol Myers - Great Speculations - Buys, holds, and hopes - Forbes on October 27, 2010 at 10:56 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 BMY, the company’s ROIC (18.6%) […]

  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

    […] our model shows Eli Lilly’s prof­its are strong and ris­ing as the company’s 2010 eco­nomic earn­ings rose over 10% to $3,740 mil­lion and reached an all-time high. Eco­nomic earn­ings have grown every […]

  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 […]

Post a Comment

Your email is never shared. Required fields are marked *

*
*