Any mismatch between GAAP metrics and business reality is a possible alpha opportunity.
You can find significant alpha within the mechanisms underlying GAAP accounting.
Investors can purchase corporations with temporarily poor figures and short-sell stocks with superficially good business reports. Entrepreneurs can higher market their equity to potential investors and beat the competition within the race for capital.
Why is there this alpha? Because analytics based on generally accepted accounting principles (GAAP) are victims of their very own success. The framework once used to value nineteenth century railroads is essentially the identical one we use today to value digital networks, raise capital for pharmaceutical candidates, and finance modern industrial projects. The model is strong, but some metrics need updating.
GAAP has two major flaws: It doesn’t show model journal entries that lead from a transaction to an organization’s books, and it doesn’t make it easy to discover the participants in each transaction. Every company has only a couple of varieties of key relationships – customers, employees, suppliers, investors, competitors, the federal government, and most people. Companies track these relationships; GAAP doesn’t.
The solution is straightforward. Go through the important thing GAAP drivers, from journal entries to public reporting, and analyze these relationships to revamp our existing metrics. I’ll prevent a protracted weekend of and begin with my conclusions:
- “Turnover” doesn’t consult with income, but to the time at which the contract is concluded.
- The money conversion cycle ought to be measured as a percentage and include deferred revenue.
- “Free cash flow” shouldn’t be free money flow, but a key figure for accrual.
- The weighted average cost of capital (WACC) should include all liabilities.
- Equity and share-based compensation ought to be valued at fair value.
How can you utilize this to generate alpha? By recognizing how the reported GAAP numbers attract or deter investment capital. It’s not enough to search out an accounting error that later corrects itself. You need to grasp how other investors trade based on this information to identify the mispricing.
Return on equity (ROE) is the glue that holds GAAP together, and that is where we’ll start.
Why cannot we just use ROE?
The idea of risk-adjusted return on capital existed long before economists invented a term for it. The ancient merchants of Venice may not have anticipated modern rules that dictate whether sales ought to be recorded this 12 months or next, but they actually gave numerous thought to their return on investment (ROI). What gets measured gets managed, so double-entry bookkeeping was introduced to trace businesses and reduce accounting errors.
In the early twentieth century
Donaldson Brown on the DuPont Company pioneered a double-entry accounting method for business evaluation. He broke down inputs into after-tax profit per dollar invested and isolated which drivers were most vital to an organization’s ROI. Today this known as Return on equity (ROE) evaluation.
The DuPont formula for return on equity
As long as revenues, expenses, assets and liabilities are accounted for accurately, decision makers can use DuPont’s ROE formula to find out where their business units are over- or underperforming.
The problem, as everyone knows, is that accounting doesn’t accurately reflect business reality.
Mapping GAAP to Relationships
Businesses are usually not based on accounting results. They are based on relationships.
No real entrepreneur needs a consultant to inform him the right way to gain a competitive advantage or generate a high return on equity. But he would love to listen to a couple of low-cost channel for acquiring customers or an untapped pool of talent. His company’s GAAP accounting results depend upon the relationships it builds and maintains.
Just as Donaldson Brown broke down return on equity (ROE) into its components, in GAAP accounting we must always categorize each item in response to the sort of business relationship it supports.
Categorization of GAAP by relationships*
This framework helps distinguish which relationships are working well and which are usually not. We can track every line item within the financial reports and determine which relationship is causing each change. Excel-related questions on quarterly analyst calls might be all but eliminated (but perhaps I’m just dreaming here).
But today, corporations not disclose their financial statements from journal entries, and their business relationships are undervalued by our current evaluation methods.
These openings are your alpha opportunity.
In the subsequent memo, we apply this recent perspective to revenue recognition, the money conversion cycle, and free money flow.
For more insights from Luke Constable, see Lampa Capital Library.
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* This simplified illustration only represents an organization’s financial relationships, but in fact not all of an organization’s relationships lead to a financial contract. To make it easier to grasp, I even have only included the relationships that fit into current GAAP reporting.
Photo credit: ©Getty Images / Vahe Aramyan
