As stated in The Disconnect Between Investment Theory and Practice section, GAAP financial statements fail to meet equity investors’ analytical needs.
Gathering all the correct data is the first step in translating GAAP reporting into economic truth.
Using critical information from the Financial Statements in 10Ks, 10Qs, and press releases and the Notes to Financial Statements, New Constructs accounting and finance experts translate reported GAAP financials into economic earnings analysis. This process requires expert knowledge and interpretation of accounting rules and economic principles. Here is a summary of footnotes adjustments and their impact.
Economic Financial Statements
New Constructs focuses on the economics of businesses rather than pro-forma or GAAP earnings.
The economic profitability of a business can be derived from the calculation of three key values:
- NOPAT (Net Operating Profit After Tax): The after-tax operating cash generated by the business, excluding non-recurring losses and gains, financing costs, and goodwill amortization and including the compensation cost of employee stock options (ESOs).
- Invested Capital: The sum of all cash that has been invested in a company’s net assets over its life without regard to financing form or accounting name. It is the total of investments in the business from which revenue is derived. Common adjustments to this value include the addition of: accumulated goodwill amortization, unrecorded goodwill, asset write-offs, unrealized gains and losses in investment securities, loan loss reserves, and capitalizing operating leases. See Appendix A for a detailed explanation of how we calculate this value.
- Weighted-Average Cost of Capital (WACC): The average of debt and equity capital costs that all publicly traded companies with debt and equity stakeholders incur as a cost of operating. The cost of debt capital is equal to the long-term marginal borrowing rate of the business. The cost of equity is calculated using the Capital Asset Pricing Model. Though there are many other more complicated approaches for arriving at a firm’s cost of equity, we do not feel their additional complexity offers commensurate accuracy. CAPM is simple, gets us close enough and it is easy to implement consistently across all companies we analyze. See WACC Definition for a detailed explanation of how we calculate this value.
The Economic Financial Statements capture the comprehensive financial picture of a business and are the foundation for an economic assessment of the profitability of any business.
Economic Value Drivers
From the Economic Financial Statements we derive the following:
- Revenue CAGR: Measures the growth of a business by calculating the Compounded Annual Growth Rate of Revenue.
- ROIC (Return on Invested Capital): The best measure of a business’ cash return on cash invested. It represents the cash flow derived from all capital invested in the business. It is equal to NOPAT divided by Invested Capital. It can also be calculated by multiplying the NOPAT Margin by Average Invested Capital Turns.
- Economic Earnings Margin = ROIC – WACC: the truest measure of a business’ profitability. This metric accounts for the cash flow returns adjusted for the risk associated with the business model employed to achieve those returns. Economic Earnings Margin precisely measure a firm’s ability to create value for its stakeholders.
- Free Cash Flow: Reflects the amount of cash free for distribution to both debt and equity shareholders. It is calculated by subtracting the change in Invested Capital from NOPAT.
- Economic Earnings: Quantifies the amount of shareholder value a company creates or destroys. It can be calculated two mathematically equivalent ways:
- Residual income approach: (ROIC – WACC) * Invested Capital = Economic Earnings
- Refined earnings approach: NOPAT – (Invested Capital * WACC) = Economic Earnings
These metrics provide investors with insight critical to assessing the merit of business models. Understanding the true economic performance of businesses is the first step in valuing any business model or strategy.