Accounting in General
Accounting is merely a financial language used to understand the performance of a company based upon the inputs and outputs into the company in question. As you know, the language is expressed in different statements, where the most crucial for the understanding of the inner workings of a company is the balance sheet, the income statement and the cash flow statement.
In this post, I will not go into details regarding accounting due to three reasons. First, many of you readers might understand the absolute basics of accounting already as you have probably taken at least one course within the subject at school of looked at a 10K more than once. Second, I happen to be finance master, so I am probably somewhat biased in the sense that we are more interested in subjects relating to finance than accounting. I try to be transparent with our biases, just like I wish any any analyst to be when doing valuations or commenting on other peoples valuations in the future. Third - and perhaps most importantly, even though accounting can be powerful in several aspects, especially in helping you grasp the specifics a company’s current and historical reality - accounting is not valuation.
Accounting is Not Valuation…
I am not saying accounting does not have a role in valuation, because it most certainly does. Accounting from a management and controlling perspective has a place in valuation and value creating activities, no doubt. I am just saying that accounting does not equate valuation. The number of times i hear and read comments from people discussing irrelevant developments in the accounting statements without questioning its connection to value-creating development in the company is simply too often.
Obviously, accounting rules must apply in the company’s future in the sense the asset and financing side of a company must always balance, the bottom line of the income statements becomes dividends or remains as equity on the balance sheet, and the cash flow statement provides information on how cash has been generated within the company and how the cash balance has changed.
Furthermore, we can look at these statements to find measures of activity (e.g. how many days does it take for a company to get rid of its inventory), profitability (i.e. how well does it generate earnings for any given level of capital put into the business), solvency (e.g. how financially sound is the balance sheet) and liquidity (e.g. how does its short term ability to pay its suppliers look like) and use the insight that they provide to gain understanding of what is going on within the company.
Nevertheless, the value of a company is the present value of all the future cash flows that it generates. I other posts on intrinsic valuation I will discuss what the present value and cash flows really mean within a valuation framework, but for now, just remember that valuation is forward looking, whereas accounting tries to help the investor understand the company today and historically, i.e. it is backward-looking. I do not mean that in a bad way, but rather I am just stating that accounting look at a company in a completely other way than finance simply because it is the accountants job to record what has happened, and it is the financial analysts job to make reasonable assumption about the future of a company.
Let me give you some examples why the accounting language can be separate from the ideas of true value. Accountants break a company’s assets down in current assets like inventory and cash, tangible fixed assets like machines, buildings and equipment, financial assets like investments in other companies and intangible assets like Goodwill. I am going to discuss that last post – Goodwill, but before we do that, take a few seconds and think about intangible assets in general. If I were to ask you to name a bunch of intangible assets, what would you think of? Most likely, you would name items like brand name, patents, customer lists, business methodologies, and trademarks. These can be extremely valuable for companies, and often be their main source of sustainable competitive advantages. Sure, you can’t touch them, but they are most certainly real. So, lets go back to Goodwill. Sounds good, right? Ironically enough, it is the most useless asset on the balance sheet, yet by far the most common intangible asset out there. Why? Simply because Goodwill is the plug-in variable that is magically created when an acquiring company buys a target company for more than the equity on the balance sheet of the target company. In other words, it is a plug-in variable to make the balance sheet balance during an acquisition. You wouldn’t think about paying for a plug-in variable, right? So why should it even matter in a valuation. There are many more examples of the drawbacks of accounting taken at face value. For example, the fact that a company can have negative value of its equity, in a financially sound, low risk company, is just mental. Take Swedish Match for example. A low WACC, High ROIC company with stable cash flows and growing revenues that has been around for ages. Yet, it has negative equity due to a history of odd accounting rules that I won't go into.
There are two key takeaways from this exercise. The first is that since the stock market systematically pays more than the equity (or Assets – liabilities) when acquiring another company, it is quite obvious that the balance sheet is a really poor measure of the value of a company. But that’s old news. The other takeaway is that maybe we should not think of a company through the lens of the accounting language, but rather in a way that captures assets that matters for a company and looks forward as the same time as it captures how the company performs today. One framework where this is possible is when we think of a company in terms of a financial balance sheet.
I would once again want to stress that it is still highly useful to be an accounting mastermind. This is especially true when trying to find potential bombshells hidden in dubious accounting choices. For example, there is something analysts sometime refer to as earnings quality. In essence, is using the knowledge of how the accounting statements fit together to examine whether income statement earnings are also visible in the cash flow statement, as to make sure that earnings are really connected to long-term value creation. If you want to read a witty, entertaining book of how to use accounting to fool investors, I recommend the book financial shenanigans.
The Financial Balance Sheet
Thinking of a company in terms of a financial balance sheet is often a technique used by Aswath Damodaran, a valuation professor, and in many people’s eyes also a valuation genius, whose ideas will be referred to many times in this blog. The financial balance sheet is both much simpler and more complex than an accounting balance sheet is the sense that it is more relevant for value and less controlled by certain accounting standards and rules but simultaneously subject to more assumptions, forecasting and subjectivity.
On the asset side if the financial balance sheet, there are two items: Assets in place and growth assets. Assets in place represent the long-lived and short lived assets from existing investments and are recorded at intrinsic value - where the cash flows, growth and risk has been considered - not at original cost or in line with some other accounting logic. The assets in place for Coca Cola are huge, and relate to all the manufacturing, distribution, brand recognition, current cost structure etc. that create the stable cash flows the ancient company is known for generating. Quite straight forward, right? Growth assets, on the other hand, are recorded at the expected value that will be created by future investments. Here, the analyst is giving credit to the company for investments the have not made yet. This requires that assumptions must be made about how the growth will look like in the future and how the great the return on these investments are in relation to the risk associated with them (i.e. the excess returns). Comparing a company like Johnson & Johnson with Snapchat, you are naturally going to assign a higher portion of the total value of Johnson & Johnson to assets in place rather than growth assets and vice versa. Obviously, earnings in the latest quarterly report can’t be the main focus for an investor in a young company, because that is not where the value of the company comes from. A young company is not a bad company just because it is young and have not had a bunch of stuff to record on its balance sheet. As you can see, it is very easy to find yourself limited by the accounting way of thinking about value.
On the financing side of the financial balance sheet, you have debt and equity. Since debt is valued at the market price of that debt, the equity is simply the residual, but is a fair value of the shareholder’s claim of the company’s cash flows since all other items on the financial balance sheet are at intrinsic value.
And there we go! We have a framework to think about value that is different from the accounting balance sheet.
This was my first post, and a very basic one indeed. In the coming posts, I will discuss the importance of the connection between narrative to numbers in valuation!