A copy of this memo was first published here by the CFA Institute. March 2021.
The market may be a weighing machine in the long run, but it sure helps to know when someone is putting a thumb on the scale.
You can generate significant alpha by understanding the mechanics that drive GAAP accounting.
Investors can buy companies with temporarily ugly numbers and short stocks with superficially good reports. Entrepreneurs can better market their equity to potential investors and beat the competition in the fundraising race.
Why does this alpha exist? Because analysis based on the Generally Accepted Accounting Principles (GAAP) is a victim of its own success. The framework we built to evaluate nineteenth-century railroads is largely the same one we use today to assess digital networks, raise capital for pharmaceutical candidates, and finance modern industrial projects. The Financial Accounting Standards Board (FASB) has, overall, done an excellent job at keeping this framework relevant. But sometimes GAAP lags business reality, and some of our metrics are in need of an update.
GAAP has two major shortcomings. First, GAAP doesn’t present the core journal entries that lead from a transaction to a company’s books. Second, it’s not easy to identify who is involved in each transaction. Every business only has a few types of key relationships – customers, employees, suppliers, investors, competitors, the government, and the public at large. Companies track these relationships; GAAP does not.
The solution is simple. Walk through the major GAAP drivers from journal entries to public reporting and parse out those relationships to reframe our existing metrics. I’ll spare you a long weekend with the Accountants’ Handbook and start with my conclusions:
1. “Revenue” Isn’t Revenue (It’s Contract Timing)
2. The Cash Conversion Cycle Should Be Measured in % and Include Deferred Revenue
3. “Free Cash Flow” Isn’t Free Cash Flow (It’s an Accrual Metric)
4. WACC Should Include All Liabilities
5. Equity and Share-Based Compensation Should Be Marked to Market
How can you use this to generate alpha? By recognizing how reported GAAP numbers will attract or rebuff capital from the investment community at large. It’s not enough to find an accounting flaw that will later resolve itself. You need to grasp how other investors will trade on that information in order to capture the mispricing.
Return on equity is the glue that holds GAAP together, so that’s where we’ll start.
Why Can’t We Just Use ROE?
The idea of risk-adjusted return on capital existed long before economists invented the term for it. The old merchants of Venice may not have known the modern rules for recognizing a SaaS contract as revenue this year or next year, but they surely thought hard about their return on investment (ROI). What gets measured gets managed, so double-entry accounting was adopted to track businesses and reduce bookkeeping mistakes.
In the early 20th century, Donaldson Brown at the DuPont Company pioneered a double-entry accounting method for business analysis. He didn't have access to a computer, so he did it all in DuPont's chart room. Brown broke down the inputs to after-tax earnings per each invested dollar, isolating which drivers matter most for a company’s ROI. Everyone today calls this return on equity (ROE) analysis.
Fig 1. The DuPont Return on Equity Formula
So long as revenue, expenses, assets, and liabilities are accurately booked, decision-makers can apply the DuPont ROE formula to identify which of their business units are outperforming or underperforming.
The problem, as we all know, is that accounting does not perfectly correspond to business reality.
Mapping GAAP to Relationships
Businesses don’t run on accounting outcomes. They run on relationships.
No entrepreneur worth her salt needs a consultant to tell her to build a competitive moat or to earn a high return on equity. She would, however, be interested to hear about a cost-effective customer acquisition channel, or an untapped pool of talented employees, or a new supplier that could reduce her cost of goods sold. Her business’s GAAP accounting outputs are tied to the relationships that she builds and maintains.
Just like Donaldson Brown broke down ROE into its constituent parts, we should categorize each line item in GAAP accounting by the type of business relationship involved.
Fig 2. Categorizing GAAP by Relationships
This framework helps to distinguish which relationships are working well and which aren't. You can follow each line item across the financial statements and dig into which relationship drives each shift. Excel-related questions on each quarterly analyst call could be all but eliminated (perhaps I’m dreaming here).
But companies today don’t report their statements from the journal entries on up, and their business relationships are underappreciated in our current methods of analysis.
Every mismatch between GAAP metrics and business reality is a potential alpha opportunity for you.
In the next memo, we'll apply this new perspective to revenue recognition, the cash conversion cycle, and free cash flow.
Fig 2 only represents a company's financial relationships, but, of course, not all of a company’s key relationships result in a financial contract. To make it easy to follow, I've only included the relationships that fit into current GAAP reporting.