Weekly thoughts #15
Accounting matters.
Disclaimer:
Eloy Fernández Deep Research publishes equity reports, and analysis posts periodically. All reports are subject to the following disclaimer.
Eloy Fernández Deep Research gathers information from public (free and paid) databases, company reports and media releases. This information is used as available basis.
Eloy Fernández Deep Research reports should only be taken as guidance. They don’t suppose an investment recommendation. Any investment decision should not be based on the Eloy Fernández Deep Research Report. Eloy Fernández Deep Research is not responsible for any investment decision or later consequences.
The opinion expressed in the reports and posts is my current opinion. This opinion is based on the prevailing market trends and is subject to change.
This post is not a BUY or SELL recommendation.
There is a trend in the financial community that tries to discredit accounting as a tool. Perhaps because they have listened to some value investing gurus, or perhaps out of convenience. In other words, if I am interested in engineering and I do not know the fundamentals of calculating structures, I could say that the calculation of turns, moments, and forces does not matter and how important it is to focus on the beauty of the building or its functionality.
The importance of purpose
Tools are not an end in themselves, but a means. They are to obtain a result.
To give another example, not all a doctor's work is to read blood tests or x-rays, but he has to use them to reach useful conclusions.
An investor must know accounting, and the more, the better. However, this knowledge must be used properly and with a purpose.
Knowledge of accounting helps investors determine an assets' value, understand a company's financing sources, calculate profitability, and estimate risks embedded in a company's balance sheet.
Just to give an example, it is incredible the number of investors who do not understand how working capital items influence the CFO. And believe me, depending on what business, it is something very important to understand.
Another example is goodwill. Everyone takes for granted what it means, but if we ask a hundred investors about it, I do not think more than twenty would know how to give a concise and accurate answer.
So much so that an expert analyst can have extensive knowledge of the business model just by taking a look at the three main financial statements (A lot of people forget or are unaware of the existence of Other Comprehensive Income): IS, BS and CFS.
Financial modelling
“Financial modeling is a set of numerical techniques used to forecast a company's future growth. Based on the information in a company's income statement, balance sheet, and estimates of future economic conditions, analysts can create sophisticated projections of an investment's future performance”. [Investopedia]
To make investment decisions we need to make a detailed study of the financial statements, projecting into the future and then making a valuation in the present time.
Although on occasion we can make a valuation by multiples, it is commonly done using DCF or discounted cash flow.
The goal of discounted cash flow (DCF) valuation analysis is to answer the question, “What is this asset worth?” But DCF is highly criticized for the following:
It requires many assumptions.
It is very sensitive to changes in assumptions.
A high level of detail may result in overconfidence.
Terminal value is hard to estimate and represents a large portion of the total value.
Challenging to estimate the Weighted Average Cost of Capital (WACC).
Even so, DCF has many pros, among which are:
Includes all major assumptions about the business.
Determines the “intrinsic” value of a business.
Does not require any comparable companies.
Scenarios can be built-in.
The key to overcoming the cons is knowing the method, doing the work properly and relativizing the result by putting it in proper perspective.
We have to think that a company operates in a dynamic environment, and that the model reflects reality under present assumptions. Therefore, the model must be subject to change and be dynamic. An analysis never ends, but works quarter by quarter.
Focus in Business Model
There is some truth in the postulates of the “enemies” of accounting. As we mentioned before, focusing on the method as an end is a bizarre mistake.
In my opinion, the process should be as follows:
Gather data (Annual reports, 10-Q, H1, presentations, press releases, expert reports, transcripts, etc.). I never select financial statements from third parties. In my experience, errors are common on certain websites, therefore only data as reported by the company.
Understand the Business model.
Adapt financial statements through the lens of the investor, building a financial model and an operating model.
Projections.
Valuation.
Investment decision.
As you can see in my analysis, the most important part is the business model. This is where I focus the efforts to understand how the company makes money, its competitive advantages, the competitors, the capital allocation and a really essential part: the management team.
Is financial analysis accounting only? No, but it matters.
If you are someone who masters accounting, that is great. If, on the other hand, you are still stuck on the subject, I would like you to answer the survey that I leave below.
Greetings and have a good week.
Eloy.
