Home etftrends.com How Accounting Can Distort Valuations

How Accounting Can Distort Valuations

By Jeremy Schwartz, CFA, Global Head of Research, WisdomTree

Last week, we had the pleasure of interviewing Baruch Lev, Philip Bardes Professor of Accounting and Finance at NYU Stern, on his views about the distortions in earnings statements that make these reports less relevant to investors. Lev wrote The End of Accounting and the Path Forward for Investors and Managers. This is an important topic we will explore in future research.

There used to be a cleaner line between the “investments” companies made to generate cash flows in the future and the “expenses” for physical structures like the buildings they needed to operate their current business. There was a clean matching between revenues and the cost for delivering those revenues.

But 25 years ago, the structure of corporations changed, and now there is greater investment in intangibles, research and development, and brands. Intangible investments are around $2.5 trillion now, and tangible investment are just half those levels.

The challenge with accounting for intangibles is that they are deducted from the current income statement, resulting in a large mismatch with the expenses generated today for future revenues.

Lev cited 2019 as a boom year, when 45% of all the companies he tracks reported losses and 70% of high tech and health care companies reported losses. While people refer to earnings as the bottom line, Lev thinks they are rather irrelevant.

In addition to the standard GAAP earnings, companies provide non-standardized measures of earnings and other non-accounting metrics to report on business trends. Subscription service companies provide customer counts, custom acquisition costs, and churn rates—none of which are accounting numbers—which can be used to determine the lifetime values of customers to illustrate the longer-term trends for their business.

Cycle of Investments 

If a firm is increasing intangible investments, its earnings are generally understated. But if it is on the downslope of investments, its earnings are likely inflated. This furthers the complications of adjusting intangibles.

Are Cash Flows Better Than Earnings?

Lev would still adjust cash flows for investments in long-term assets—essentially intangible investments—as those lower current cash flows.

Will Officials Ever Change the Standards? 

The accounting board deleted intangibles twice from its agenda of reforms, so Lev is not optimistic the standards board will get this right.

Lev also recently wrote a paper, “Explaining the Recent Failure of Value Investing,” that looks at where value strategies went wrong. One finding was that value investing relied on “mean reversion” and a “bouncing up” of stocks that were depressed in valuation and a “bouncing down” of stocks that were at higher valuations. Mean reversion has slowed down in the last 20 years, and Lev thinks the displacement of top companies is different now: The intangible investments give more protection, while the companies with low valuations don’t make enough intangible investments to move up.

You can listen to this important conversation at the link below.

Originally published by WisdomTree, 11/24/20


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