Numbers are the basis of fundamental analysis. Investors can customize spreadsheets that allow for set inputs to quickly trigger mathematical answers. In a few hours we can create tools that instantly crunch numbers for us years into the future.
While this sort of instant accounting is appealing in many ways, we must also be cautious. A common saying that applies to any quantitative method is that garbage in brings garbage out. If our inputs are flawed, no amount of upfront programming will correct for the errors that occur.
When we solve for fundamental ratios, we use the income statement and balance sheets that are audited and provided by each company. Since all companies filing financial statements with the Securities and Exchange Commission (SEC) must use Generally Accepted Accounting Principles (GAAP), many investors assume they can take the numbers and immediately put them to use. This approach is logical, but it may result in large miscalculations that will lead your investments astray.
GAAP is a rules-based system that attempts to outline how certain transactions should be accounted for. Such a system seeks to standardize reporting across companies, but instead has the effect of distorting results. If a company does not like the outcome yielded by a given GAAP rule, it can enter into a different transaction with similar economic benefits, yet more company-friendly accounting results. For this reason, we must examine how a company constructs its financial statements before typing the numbers into our ratio calculators.
The nuances of GAAP adjustments are so numerous that they are covered by entire books. Instead of going for a comprehensive view, I will highlight the five main categories to look for and how investors should treat these events. The five main areas of concern are:
1. Operating leases – A company needs space to operate its business. A service company could look for office space, a manufacturing company needs factories, or a retailer storefronts. There are a few different ways of acquiring this space. Some companies will build or buy a building, but most others will rent. The accounting difference between owning and renting real estate is enormous. If Company A buys a building for $100,000 and agrees to pay $20,000 in mortgage payments per year for five years, the amount goes to the balance sheet as a liability. If Company B wants the same space, but decides to rent at the same $20,000 per year, it can structure the transactions as an operating lease without putting the liability on its balance sheet. Although both companies will occupy the same space and have the same future expense over five years, Company B’s balance sheet looks much less risky. To correct for this issue, I recommend investors bring all operating leases onto the balance sheet in order to make the comparison apples to apples.
2. Pension status – Many companies have pension plans for their employees. These assets are all invested in a similar manner and the promises they make for the future are fairly routine. However, their appearance on a balance sheet is not. When calculating pension liability, GAAP allows companies to make an estimate of future investment returns. Doing so allows companies to smooth their results so that one bad year does not create a temporary hole in a company’s balance sheet. However, this flexibility also causes distortions between companies. Pick a few companies from any industry and pull their pension footnotes and you are bound to see large differences in future expected returns despite similar investment goals. To correct for this issue, determine what you believe is the proper rate of return and standardize all companies to that rate.
3. Stock options – For years, stock option expense did not appear on income statements. Changes have been made to GAAP that allow the expense to appear. However, I believe that GAAP rules misrepresent the expense. By measuring the option expense only at the time of issuance, GAAP misses whatever value change may have occurred between that date and expiration.
To better understand this nuance, consider an example. Company A’s stock price is $10. It issues 100 million options to employees exercisable at $10 that will last for 10 years. Based on an option calculator, these options are worth $3 each, so Company A realizes an option expense of $300 million. Four years later, the business has performed well and the stock price is $50. The employees look to cash in their windfall and use the options to buy the shares for $10 and immediately resell them for $50. This is where things get murky. At this point the company can let the shares be sold into the market or purchase them back from the employees. Nearly every company decides to repurchase the shares. This results in Company A paying $50 to the market so it can sell to the employees at $10—a net cost of $40 per share, or $4 billion. Nowhere on the balance sheet does the difference between the true cost to the company of $4 billion and the GAAP expense of $300 million appear. To correct for this oversight, I recommend expensing the difference.
4. Currency – Many investors buy multinational companies when the dollar weakens because their sales will occur in a stronger currency and then be sent back to the United States. These investors should refrain from this practice. If Company A produces a product in New Jersey for $1 and then sells it in Paris for €1, currency does not alter the economics of the business. Instead, currency confuses. In this example, assume that today $1 equals €1. On today’s sale no money is made because the value of the euro is the same as the dollar and the sales price equals production cost. Now assume that tomorrow exchange rates change and $2 equal €1. In this case, the company receives $2 when it sells one product in Paris. Most investors rejoice and bid up the shares of the company. In reality, the economics of the business have not changed, only the exchange rate has. While the rate difference may bring more money back to Company A, the same results could be achieved by producing the product in New Jersey, selling it in New Jersey, and speculating in the foreign exchange markets. No one would pay a multiple of earnings for currency speculation, but investors do when they translate international results. I recommend removing all currency effects to eliminate this error.
5. Deferred taxes – When a company files a tax return with the Internal Revenue Service (IRS) it uses different accounting standards than when it reports GAAP earnings. Certain timing differences, such as depreciation, create differences between the amount of taxes paid and those on the income statement. These time differences become a deferred tax asset if more taxes were paid to the IRS in the current year, or a liability if less tax was paid to the IRS in the current year. Since these events are purely timing differences, we expect the deferred tax asset or liability to disappear over time. However, it often does not. Since normal business events cause these discrepancies, they are perpetually created. Only when the company ceases operating will the difference disappear. For this reason, I often exclude deferred taxes from the balance sheet. I have no desire to buy a company with a dying business in the hope of capturing deferred tax assets. When you consider that most companies with large deferred tax assets never capture their value, you will appreciate this approach.
GAAP has done wonders for financial analysts by standardizing financial reports and making numbers comparable. However, we cannot always accept figures at face value. Learn to adjust GAAP where needed and your financial results will improve.