Finance 101

Finance is the process for making accounting data useful.

Incomplete accounting data not only has low utility but also can be misleading. The only way to have a complete set of accounting data is to gather many critical data points from the Notes to the Financial Statements.

Per Accounting 101: accounting data (i.e. the financial statements: income statement, cash flow statement and balance sheet) by itself is not useful. One must analyze and gather data from the Notes to the Financial Statements in order to convert accounting data into economic earnings.

Think of accounting data as the words used in the language of Finance. Just as with any language, words can be arranged to convey almost any meaning. Arranging accounting data to tell the truth about profitability requires a substantial amount of work to:

  1. Gather all the accounting data PLUS data from the Notes to the Financial Statements
  2. Leverage expertise in both accounting and economics to understand the data and its impact on profitability and valuation
  3. Build models that analyze and interpret all relevant data correctly

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 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 Metrics 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 Education 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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