The Accountant versus the stock valuation analyst
Accountants and stock analysts often disagree on which expenses are
"real" or relevant and which if any can be ignored.
For example, the accountant believes that goodwill and virtually every other
asset (with the notable exception of land) should be depreciated or charged
against income over a suitable number of years. In contrast, the stock analyst
often argues that depreciation and amortization should not be deducted in
arriving at the relevant net income for stock valuation purposes. Since the accountant
has already deducted these items, the analyst often "adds them back"
to net income.
The accountant believes that unusual gains and losses such as restructuring
charges and gains on asset sales need to be accounted for in net income. The
analyst argues that these one-time items need to be added back to arrive at the
adjusted or recurring earnings.
Who is correct? the analyst or the accountant?
Actually both are correct. They each have different goals in measuring
earnings and their different purposes require differing methods.
The accountant is interested in measuring the income earned by the original
investors in a company. The accountant is always reporting historical
figures.
In contract the stock analyst is interested in historical earnings only to
the extent that they provide clues about future earnings and cash flows.
The accountant depreciates an asset to account for its original cost. The
stock analyst in contrast considers the original cost of an asset to be
irrelevant and instead is interested in the future capital spending that will
required to replace the portion of assets that were worn out during the
year.
Why analysts and investors care about earnings.
In theory, a share in a business is worth the "present value" of
all future net cash flows that are expected to accrue to that share.
If companies provided useful figures on the net free cash flow generated each
year then investors would probably be better served to focus on that figure,
rather than on net income. The accountant's cash flow statement
reconciles beginning and ending cash but unfortunately mixes up the capital
spending needed to replace worn out assets with the discretionary capital
spending which is intended to grow the business. Therefore, the accountant's statement of cash flows
does not clearly reveal the amount of free cash flow generated. And companies (with rare
exception) simply do not provide a supplemental disclosure of free cash flow.
Investors therefore tend to focus on net earnings because it is usually the
best available estimate of sustainable free cash flow generation.
When a stock analyst looks at earnings or cash flow he or she (paradoxically)
is not primarily interested in the earnings for that year. He is really
interested in using current earnings to project the future stream of earnings or
free cash flow since a share is worth the present value of future cash flows.
The analyst must always adjust reported net earnings for any unusual
one-time gains or losses in order to arrive at the sustainable, recurring
earnings.
The analyst has a completely different view of depreciation, as compared to
the accountant. Depreciation as such is a non-cash charge. It does not affect
cash flow and is therefore not directly of interest to the analyst.
However, the analyst is very much concerned about assets wearing out and needing
to be replaced. The analyst wishes to estimate the present value of capital expenditures
to replace assets that were worn out in achieving the years net income.
Therefore, ideally the analyst will add back depreciation to the accountant's
net income and then subtract off the present value of the capital spending
that will be needed to replace the assets that were worn out or depleted in
earning the year's income. Unfortunately, in practice, there is usually no
estimate available of the capital spending that will be required to replace worn
out assets. The analyst will often accept the accountant's depreciation as a
reasonable approximation of the ultimate cash flow impact.
But there are a few notable exceptions. Goodwill is usually amortized for
accounting purposes. But goodwill is usually not a wasting asset. It may never
need to be replaced. On that basis the analyst can ignore this amortization as
an expense. Depreciation of a building is charged by the accountant. But an
analyst may determine that the actual capital spending to replace building after
it is "worn-out" will not occur for say 35 years. In this case the
present value of that capital spending (even after inflation) may be much
smaller than the depreciation charge. In this case the analyst may add back most
of the depreciation charge on the basis that it (and the ultimate capital
spending 35 years hence) has no material impact on the present value of cash
flows. This explains why real estate is usually analyzed on a cash flow basis
rather than on net income. The net income of a real estate company may
consistently under-state its cash flow, while for for many other companies, that
would not be true.
The purpose and meaning of the net earnings reported by the Accountant
under GAAP.
Accounting Net Income is meant as a performance measure. Over the life of a corporation
the total net income is precisely equal to the net free cash generated by
the business. Over any long period of years, the total net income is
usually approximately equal to the net free cash generated by the business.
The major goal of accounting is, as the name implies, to give an accounting
of the business during the year.
The income statement attempts to show in a fair manner the share of the total
net cash that "belongs" to each particular year or period of time.
However, income is measured on an accrual basis and not on a cash basis. For accounting purposes, we do not care when the cash will be received. To
the accountant a dollar to be received in two years, is just as good as a dollar
received now.
Accounting net income is very much affected by the historic cost of invested
assets, and not at all affected by the future cost to replace worn out assets. For example the historic cost of a building may be amortized as an
expense over (say) 20 years. Whether or not he building has to be replaced at
the end of 20 years or what it will cost to replace the building at that time
has no bearing at all on the Accounting net income.
The accountant measures the net income from the perspective of an original
investor in a company. The accountant amortizes goodwill because it was paid for
and must be charged against income over a period of years to arrive at net
income.
Land is not depreciated on the assumption that it does not wear out and can
be sold for (at least) its original cost at any time.
The accountant includes unusual gains and losses in net income because they
do contribute to the return earned by the original investors in a firm.
Conclusion
The accountant and the analyst will always differ in their opinion of the
"true" net income because they employ different methods driven by
their differing goals. The accountant is historical oriented and asks how much
did we make? The analyst is future oriented and asks what is the level of
recurring income that can be used to predict future income? (and therefore the
value of the shares).
Shawn Allen, CMA, MBA, P.Eng.
January 11, 2002
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