INTRODUCTION
There are many ways to slice and dice the stock market to figure out reasonably optimal entry and exit points in order to make money from stock price movements, from looking at charts to creating forward-looking valuation models, and even anticipating what central bank policies would be. There are endless sources of information from analysts, brokers, fund managers, and various experts that make the financial markets that much more exciting and dynamic.
I’ll throw my two milkshakes worth of thoughts into the mix by focusing on something purely objective: historical financial statements.
While it is true that the past can never provide a perfect prediction of the future, I think it’s worth spending a little time dissecting the historical financial statements of a company just to see what the track record looks like. This is where it gets a bit challenging…and interesting. Dissecting financial statements requires at least a basic understanding of accounting. For many people, accounting is a dreaded topic.
I won’t bore you with the mechanics of accounting, finance, and valuation. There are other sources that you can tap to explain deeper concepts. I’ll focus only on what’s reasonably relevant to understand and appreciate the track record of a business.
TFI ANALYSIS
The first important point that I’d like you to keep in mind is: “Any business is defined by a few important core assets. Everything else is fluff.”
“Core assets” are the productive operating assets that you would expect to see on a daily basis that create benefits for the company. For example, the important core assets of a grocery store would include cash, accounts receivable, inventory, store space, and the employees. Yes, the employees…I’ll get to that shortly.
“Fluff” items are the things that appear on the financial statements due primarily to the nuances of accounting standards. The “fluff items” are not important. Our goal is to try to understand what makes a business work based on the core assets.
Second, almost all companies proudly say that their single most important asset is the workforce…the employees…the people who work for the company. However, the rules of engagement in the world of accounting forbid “employees” to appear in the financial statements as “assets”. Ironically, the single most important asset is reported as an expense…i.e. “salary expense”. This obviously creates a problem if the “assets” of a company are assessed based simply on what’s reported as “accounting assets”.
In the analyses that follow, I take a non-standard accounting approach by analyzing “employee salary expense” as an asset item. I call this Employee Value Creation (EmVC)™. In addition, “executive compensation” is assessed separately to get a feel for the productivity of the executives. I call this Executive Value Creation (ExVC)™.
Third, keep in mind that all businesses start out on Day #1 of existence with only one asset: cash. As the days, weeks, months, and years go by, cash is used to buy other types of assets, such as inventory, furniture, equipment, etc. But how efficiently are these operating assets managed? The standard “working capital” metric is used to gain insights into the management of three important day-to-day operating items: inventory, accounts receivable, and accounts payable.
Finally, due to the distortions created by accounting rules, the popular bottom-line “net profit” is not sufficient in assessing the performance of the business. If a company is profitable, does it follow that it “created value”? A different concept called “economic profit” will be used alongside the standard accounting profit metrics in order to gain better insights into the company’s performance.
INVESTOR VS. PHILANTHROPIST
Are you an Investor or a Philanthropist?
Broadly speaking, any of the following definitions could be used to define an investor:
- A person who invests in the stock market with the expectation of getting a return on investment (ROI) in the form of stock price appreciation, dividends, or both.
- An entrepreneur who starts a business with the expectation of generating profits.
- A person who lends money to a business in exchange for interest.
In fact, you might have your own definition. Whatever the definition is, there is one common thread: receiving a return on the investment. Finance literature is overflowing with theoretical frameworks and empirical evidences about what constitutes an adequate return on investment. I won’t get into that.
Now think about it: What if the investment turns sour? What if the stock that you bought doesn’t go up, but instead go down? What if the business of the entrepreneur hovers somewhere at the breakeven area? What if the lender is not paid the interest? Then the investor has turned into a philanthropist, albeit unwillingly.
Loosely speaking, a philanthropist is a person who helps other people. How is this relevant?
A business that is hovering at the breakeven area is probably able to pay its suppliers, thus helping with the suppliers’ business. Employees also get paid, thus creating employment. Taxes are paid to the government, thus contributing to national welfare.
Not everyone is cut out to be a philanthropist…however many participants in the financial markets are nudged into it unwillingly.
So…are you an investor or a philanthropist?
