How Alpha Hides in GAAP Accounting: Return on Equity

How Alpha Hides in GAAP Accounting

Every mismatch between GAAP metrics and the reality of work is a potential alpha opportunity.

You can find an important alpha in the mechanisms that drive GAAP accounting.

Investors can temporarily buy companies with ugly numbers and short stocks with apparently good reports. Entrepreneurs can better market their stock to potential investors and beat the competition in the fundraising race.

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Why is there this alpha? Because analysis based on Generally Accepted Accounting Principles (GAAP) is a casualty of its own success. The framework once used to evaluate railroads in the 19th century is largely the same framework we use today to evaluate digital networks, raising capital for pharmaceutical candidates, and financing modern industrial projects. The model is solid, but some of the metrics need an update.

GAAP has two major flaws: it doesn’t show sample journal entries that lead from a transaction to a company’s books, and it doesn’t make it easy to identify the participants in each transaction. Every business has a few types of key relationships—customers, employees, suppliers, investors, competitors, government, and the public in general. Companies follow these relationships. GAAP no.

The solution is simple. Explore key GAAP drivers from journal entries to public reports and extract those relationships to reformulate our current metrics. I’m going to give you a long weekend Accountants Handbook And I start with my conclusions:

  1. “Revenue” isn’t revenue – it’s the timing of the contract.
  2. The cash conversion cycle should be measured as a percentage and include deferred revenue.
  3. Free cash flow isn’t free cash flow – it’s a cumulative measure.
  4. The weighted average cost of capital (WACC) should include all liabilities.
  5. Equity and compensation should be marked on the basis of shares in the market.

How do you use this to generate alpha? By recognizing how reported GAAP numbers will attract or repel investment capital. It is not enough to find an accounting defect that will resolve itself later. You need to understand how other investors will trade on that information in order to catch mispricing.

Return on equity (ROE) is the glue that holds GAAP together, so that’s where we’ll start.

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Why can’t we just use ROE?

The idea of ​​risk-adjusted return on capital existed long before economists invented the term for it. Venetian merchants of old may not have anticipated the modern rules on revenue booking this year or next, but they certainly thought hard about return on investment (ROI). What gets measured is managed, so double entry accounting has been adopted to keep track of business and reduce bookkeeping errors.

In the early 20th century, Donaldson Brown of DuPont pioneered the double-entry accounting method for business analysis. He broke down the inputs into after-tax earnings for each dollar invested, and isolated the drivers most important to the company’s return on investment. Everyone today calls this return on equity (ROE) analysis.

DuPont’s return on equity formula

Diagram Showing Dupont'S Roe Formula
Source: Lamba Capital

As long as revenues, expenses, assets, and liabilities are accurately booked, decision makers can apply the DuPont ROE formula to determine where their business units are performing or underperforming.

The problem, as we all know, is that accounting doesn’t quite align with business realities.

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GAAP mapping of relationships

Companies do not act on accounting results. They run on ties.

No entrepreneur worth their salt needs a consultant to tell them how to build a competitive moat or to earn a high return on equity. However, they would like to hear about a cost-effective customer acquisition channel or an underutilized pool of talented employees. The GAAP accounting outputs of their business are related to the relationships they build and maintain.

Just as Donaldson Brown broke down the ROE into its component parts, we must classify each line item in GAAP accounting by the type of business relationship involved.

Classification of generally accepted accounting principles by relationships*

Gaap Chart Tracking Measures Of Relationship
Source: Lamba Capital

This framework helps distinguish between relationships that work well and those that don’t. We can track each item across the financial data and research the relationship that drives each turnaround. All Excel-related questions can be left out on our quarterly analyst calls (though maybe I’m dreaming here).

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But companies today do not report their data from journal entries upwards, and their business relationships are underappreciated in our current methods of analysis.

These slots are your alpha chance.

In the next note, we’ll apply this new perspective to revenue recognition, the cash conversion cycle, and free cash flow.

More ideas from Luke Constable can be found at Lamba’s Capital Library.

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*This simplified figure only represents the company’s financial relationships, but, of course, not all company relationships result in a financial contract. To make it easier to follow, I’ve only included relationships that fit with existing GAAP reports.

All posts are the opinion of the author. As such, it should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Photo credit: © Getty Images / Vahe Aramyan

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