Category Archives: Accounting

Hedge Fund Analyst Quiz

You just joined as a new analyst and your boss slaps this on your desk Adobe 2000 10K.   What is the real net income to shareholders? Assume a 35% tax bracket.

You remember from reading in Berkshire Hathaway’s 1992 annual report, “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”

FAJ Stock Options and the Lying Liars Who Dont Want to Expense Them  No need to read this to answer the question.   detective



An answer will be posted next week.    The correct answer will garner a prize and adulation.

The END of Accounting?

end of accounting

The End of Accounting An article from the Wall Street Journal. Some may wish to read this book.  On the other hand, we all should know the limitations of accounting.   Accounting was designed for credit analysis while business analysts must use more conceptual, creative thought to understand the economics of the business they are analyzing. Use the proper tool in the proper way–understand context.


I got on the wrong bus. HELP!


A Money Problem


We Don’t Have a Wage Problem; We Have a Money Problem

FYI: GAAP Acccounting gatech_finlab_lifo_42216

Don’t Spare the Rod: Critique of Investment Research Reports

Time WarnerA beginning analyst sent me a research report to discuss: Ensco PLC Write-Up

Now before I start, realize that when I was beginning, my idea of a research report was to mimic Cramer.  Buy because the “chart” looks good and I gotta feelin’.  One time my hedge fund boss said his time was worth $1,000 an hour so the six minutes he took to read my incoherent report meant that I OWED HIM, $100.  Well, we all have to start somewhere.  The point of this exercise is to learn.

Buffett’s punch   idea may apply. If you only had twenty investment ideas over a lifetime–one every two to three years–would this be it? Would you put all of your money and family’s money into the idea and why?

Or, you pretend that you have a 45-second ride in the elevator to the top of the Time Warner building with Carl Icahn while selling your idea.

Bill Miller once said that money managers had the attention span of knats. You had to summarize your thesis and then give three or four supporting reasons within thirty seconds.

My critique of Ensco PLC

Instead of four paragraphs to tell me what Ensco does, perhaps you can be more succinct while putting forth what is compelling about your investment thesis.

ESV (Ensco, PLC) is an owner/operator of offshore contract drilling rigs/services that is trading at X% under tangible book value.  This is a cyclical, asset-intensive business subject to swings in natural gas and oil prices. Over a fully cycle, the company earns normal returns on capital of XX?

The price: Enterprise Value

Returns: over several prior cycles?

Capital structure and terms of debt?

Bottom line: this is a non-franchise or asset-based investment that is currently and cyclically out of favor.  OK.   But if this is an asset based business what are the assets worth?  You would need to dig into tangible book–what is there?   What is the current and expected replacement value of their assets? Liquidation value?  Is their fleet of rigs unique? Who are their competitors?  Any hidden assets or potential assets like, say, NOLs or assets outside their core business for example?

What is their cash flow and owner earnings?   I would like to see enterprise value over EBITDA-MCX over the past decade to get an idea of how the market priced ESV over a cycle.

Who is management? What skin do they have in the game? Are they good operators and capital allocators? Insider buying?  Who owns this company?  I don’t have much to go on in the above report so I jump to my handy VL: ESV_VL.  Whoa!  I see debt has jumped about 35% from 2013. How does their capital structure compare to competitors?   It seems like there isn’t much free cash flow. Capex eats up most of the company’s cash flow.

Where is the margin of safety? Book value has been growing but during an up-cycle in drilling. What happens in a prolonged down-cycle?  What are the risks?   You mention a DCF? Where did that come from? Your assumptions?

I will let others in the Deep-Value group chime in, but for a first-ever research report I give a D- which isn’t bad. At least the writer has good instincts to look at an out-of-favor company, but the core analysis of the assets needs to be provided. Also the competitive landscape.  Obviously, it is a business without a competitive advantage due to the low and cyclical nature of the returns, so how does this business compare operationally, financially and value-wise to their main competitors? Who are their customers and how are they faring?

The only way to improve is to write, practice and look at other reports. Go to and sign up. Then look at the highest rated ideas and study those along side the 10-K of the company mentioned.

Study Other Examples of Research

Or The_Security_I_Like_Best_Buffett_1951  Warren Buffett on Geico. (you may have to paste into your browser) and as reference, Rockwell Automation Inc and ROK_VL from a Deep-Value member, Thomas Harris. We can critique this next if you wish.

Carl Icahn paid $500,000 for an investment bank to furnish a report on breaking up Time-Warner: lazard_twx (worth a look!) and Icahn was right about Time Warner

Analyzing Debt

Sell ABX

ABX Sombull along with Barrick Annual Report 2014 and Barrick 1 Q 2015

Stay with it………writing is hard and finding great ideas even harder.

Measuring Financial Distress Chapter 4 of Quantitative Value



The corpse is supposed to file the death certificate. Under this “honor system” of mortality, the corpse sometimes gives itself the benefit of the doubt. -Warren Buffett, “Shareholder Letter,” 1984

Cryin’ won’t help you; prayin’ won’t do you no good. –My Ex.

We take up from Chapter 3 and move to Measuring the Risk of Financial distress: How to Avoid the Sick Men of the Stock Market in Chapter 4 of Quantitative Value (which you have if you are in the Deep-Value group at Google Groups).   I will email Financial Shenanigans as a supplement to this chapter of uncovering distress/fraud.

Can one predict financial distress from the outside of a company BEFORE bankruptcy. Obviously, the first place to look is at the balance sheet for the quality of the assets vs. the terms and amount of the debt. Then look at the competitive nature of the company’s industry. Airlines tend to go bankrupt more than cola companies.

I think you must practice your skills as a financial analyst. When you read about a bankruptcy like Radio Shack, then download the financials for your records and look back for what signs you might have noticed.  I will have other tips below.

Several research papers and case studies mentioned in Chapter 4 below. Especially look at the WorldCom case.


_predicting_financial_Distress Risk 2010

Forecasting Bankruptcy More Accurately

Predicting Bankruptcy for Worldcom Final

WorldCom1 Ethics Case Study

Litigation against WorldCom for Fraud

Enron CS


WorldCom Accounting Fraud


Practice your skills

You can look at these research reports from Off Wall Street and then download the financials of the companies mentioned and see if you can recreate the analysis.






Blood in the streets!


Gold Mining a Crappy Business

Why Gold Mining is a Tough Business_Pollitt (An interesting insight into this industry)
SEE YOU NEXT WEEK as we go into Chapter 5 in Quantitative Value.

Practice Like Jonah!

Screening out Earnings Manipulators; Quality of Earnings

budget cuts

Accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require to engage in further accounting maneuvers that must be even more “heroic.” These can turn fudging into fraud. (More money, it has been noted, has been stolen with the point of a pen than at the point of a gun.)” –Warren Buffett, Shareholder Letter, 2000.

We pick up from the last lesson and read Chapter 3 in Quantitative Value: Hornswoggled! Eliminating Earnings Manipulators and Outright Frauds.

This is an important chapter for improving as an investor. Your goal might be to understand accounting up to the intermediate level so as to adjust accounting principles into economic reality. What story are the numbers telling you?

Think of this chapter as a way to build an early-warning system for companies with weak accounting.

The authors propose three ways to detect aggressive accounting that lead to poor quality of earnings:

  1. Scaled total accruals (STA), which uncovers early-stage earnings manipulations
  2. Scaled net operating assets (SNOA) which captures a management’s historical attempts at earnings manipulation.
  3. The third is the probability of manipulation, or PROBM, a tool that identifies stocks with a high probability of fraud or manipulation.

When the growth in cumulative accruals (net operating income) outstrips the growth in cumulative free cash flow, the balance sheet becomes “bloated.” Stocks with balance sheets bloated in this way find it difficult to sustain earnings growth.  When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen.

A warning sign is high accruals that show much higher income than cash flow. See pages 64 to 68 in Quantitative Value.

Though you should read this chapter carefully and for the nerds, dig into the research papers below, but I highly suggest studying Chapter 8 in Quality of Earnings, Chapter 8 (sent via email to Deep-Value at Google Groups).   A gem of a book. and Defining Earnings Quality CFA Publication

Earnings Management, Fraud Detection and Adjusting for Accruals

How a group of Cornell Students sold Enron before the collapse

Information in Balance Sheets for Future Stock Returns

Earnings Mgt and LR Stock Performance of Reverse LBOs

Earnings Mgt and LR Performance of IPOs 1998

Can Forensic Accounting Predict Stock Returns

Analysts do not adjust adequately for accruals 2004

After a few days of digesting this post, we will tackle Chapter 4: How to Avoid the Sick Men of the Stock Market, in Quantitative Value.

How can we avoid bad news as investors through our knowledge of financial statement analysis and human motivations (incentives)?

Sound Money


A Banker for All Seasons John Exeter

An American Original: Voodoo Child

Have a Great Weekend!


Tawes Hockey

POP Quiz: Is a Rising ROE Good?


I intend to live forever. So far, so good–Steven Wright

We will tackle Chapter 4 in Deep Value next week and I will find out the status of the forum for advanced students this weekend. I am swamped. 


If a company is increasing its Return on Equity (“ROE”) over time, is that an attribute of a good business?   

Since you are skeptical, you whip out your ROE diagrams:




Even better, you are hired as the investment banker to help advise the CEO how to enhance ROE (bonuses are based on rising ROE and increasing earnings per share).

Today, the company receives 0.00000000000001% on its money market accounts, while the CEO’s company stock trades at 34 times earnings and earns its cost of capital, 10%.   Remember, you work for JP Morgan and you have student (MBA) loans to pay off.  You sharpen your pencil and……………….?

My thoughts posted this weekend after I pass out grades.

Post: Feb. 16, 2015

Damn! I am unable to flunk anyone. There was a good discussion looking at the question from many sides because I didn’t give you much detail.  The key point is: “It depends.”  Context is key.  You could have a situation like Microsoft’s where its core businesses (Office, etc.) generate so much cash without incremental investment that cash builds up and in turn drags down ROE (equity grows without a high return on the cash). Then the issue becomes what will Microsoft do with its excess cash? Squander on new ventures and acquisitions or return it to shareholders?  Microsoft over the past six years has done a little bit of both. Perhaps low ROE means the company has no debt and thus a buffer during cyclical down turns?

Maybe this company’s ROE is suppressed by last year’s investment into new stores and more time is needed before the stores earn their expected return. Perhaps, like Costco or Philip Morris, future growth will be so profitable and persistent that buying in shares means reducing shares below intrinsic value–a long shot, how many emerging Wal-Marts, Costcos or Whole Foods are there?

The popular move which I, as a JP Morgan banker, would advise the CEO to buy back his stock with his low yielding cash (about a 0%) return and lather on low cost debt to buy stock back  to earn an approximate 3% return (1 divided by 34) despite being a mundane business (10% ROE). Even at inflated prices. You shrink share count and equity to drive up EPS and ROE. The CEO collects another bonus and you can chirp about your value enhancement strategies.  But when you buy an average company at 34 times earnings, you are paying over intrinsic value (let’s assume). Earnings and ROE rise but book value drops. Long-term wealth is reduced.   Look at tech and consumer good companies today where managements are buying in their stock near all-time highs after a six year run-up.  Few bought shares in the depths of the 2008/09 crisis.  Borrow money today at 3.5% to buy-in your stock at a 5% earnings yield. Brilliant–until the next economic downturn.

This is another lesson in incentives. CEOs are incentivized to get a short-term bump in their stock prices, long-term value be damned.

GOOD JOB to all who commented.

Negative Equity Companies



CLF-2014 Year End Earnings-Release  $7.5 billion write-off and thus $1.4 billion in NEGATIVE equity.  Headed to bankruptcy?  I wouldn’t bet on it, but there go the screens for low multiples of book value.   Investors typically run from stocks like this.


Revlon VL has had negative equity for over a decade, but increased cash flow is what has driven this stock higher.


Negative shareholder equity–at least from a securities perspective–is not a problem in and of itself generally in the U.S. It can result from any number of corporate histories. Corporate valuations tend to vary widely from their shareholder equities. I am not aware of any state’s corporate law that considers it a problem, in and of itself, either. In Delaware, the measure that matters is “surplus,” which is drawn from a corporation’s market value rather than its book value. Delaware corporations, for example, can pay dividends, borrow money, issue new securities to investors, etc. notwithstanding a negative s/h equity, so long as they have adequate “surplus” meet minimum capital and other legal requirements. I would say s/h equity, while important, is seen more as an accounting function that can-but does not always-track the actual value of a company. The only time I have ever seen it come up as a legal matter is in the case of one company that wanted to self-insure itself for workers compensation liabilities. The state denied the company’s application to self-insure on the basis of negative shareholder equity–notwithstanding its market capitalization was in the hundreds of millions. It was just a requirement buried in the state’s regulations that used s/h equity as its measure of a corporations value (and, thus, its ability to pay worker’s comp claims).

Jun 2, 2013

Oscar Varela · University of Texas at El Paso

Look at Revlon. Here is a firm with about 1.2 bil in assets and 1.9 bil in debt, giving it negative equity of 0.7 bil. This is less than it was a few years ago, when its equity was about negative 1 billion. Yet it survives, and is an NYSE firm.

Timothy R. Watts · University of Alaska Anchorage

Your example is very good because it shows that a change in stockholders’ equity can be a good measure of performance. Revlon’s increase in s/h equity shows that it is performing well, even though it is negative (and will probably be for years to come). Although, like book value, there are plenty of other reasons s/h equity change absent a valuation change. A general example is companies that have (from prior years) built a huge bank of net operating losses (NOLs), which can shield a company from tax liability for a long time. These NOLs, while having value cannot be booked as assets unless the company is showing, according to accounting standards, that it will actually use them. Once a company that has been losing money (and accumulating NOLs as well as, likely, shareholder deficit) becomes consistently profitable, these NOLs can be booked as an asset. The asset is the value of future tax savings. That can turn a company’s negative book value into a positive book value overnight–even though the company’s market value hasn’t changed at all. This can also happen the other way. I recall this happening to Ford around the time of the financial crisis. They booked a massive loss in one quarter largely on the basis of the elimination from their balance sheet a tax asset based on the value of their NOLs. It was a bad quarter for them to be sure (like everyone else), but the accounting loss magnified it several times in a way that didn’t track performance. Ford, after all, was the only major car company in the U.S. that avoided bankruptcy during the crisis.

Jun 7, 2013


I bring the negative equity to your attention because it seems like a good search strategy to find mis-valuation.  First, many screens wouldn’t pick these companies, second most investors would shun them, investors often fixate on accounting convention rather than underlying economics, and finally it seems very counter-intuitive.

Note the article from an early post in this course: Behavioral Portfolio Management

If anyone wants to study this further, let me know.

Question on ROE vs. ROCE; Comprehensive Look at EBITDA

EBITDA and an interesting look at margins here:

Respecting the Reality of Change

The following chart shows CPATAX divided by GDP from 1947 to present.  The black line represents the average from 1947 to 2002, and the green line represents the average from 2003 to 2013.


As you can see in the chart, CPATAX/GDP is wildly elevated at present.  It currently sits 63.3% above its average from 1947 to 2013, and a whopping 75.0% above its average from 1947 to 2002.

As readers of this blog have probably inferred by now, I’m not very patient when it comes to waiting for “mean-reversion” to occur.  In my view, when a variable deviates for long periods of time from a reversion pattern that it has exhibited in the past, the right response is to expect something important to have changed–possibly for the long haul, such that a predictable reversion to prior averages will no longer be readily in the cards.  The task would then be to find out what that something is, and try to understand it. Go here:   (Interesting blog)

Reader Question:

Can you help me understand one aspect of ROE? In Indian companies, some of the companies have ROE < ROCE.

Isn’t that a violation of the observation that ROE ~ ROCE times Leverage.

I define ROCE as Return on Capital Employed.

ROCE = EBITDA (1-Tax Rate)/Total Capital Employed (=Debt+Equity)

I use ROCE as a measure of the attractiveness of the industry and the company. High ROCE is good, implying a moat, low ROCE is not.

Some of the reasons I could think of are:

  1.  Exceptional losses, which lead to Net Income << EBIT(1-Tax) *Leverage
  2.  Extremely high interest charges. ( higher than return on the        debt portion) which leads Net Income << EBIT(1-Tax)* Leverage
  3.  There is a slump sale of a division, and thus suddenly huge            amount of profit has come in increasing inordinately the            average shareholder equity. So suddenly the effective leverage        has dropped.

Update May 1: 

I made a mistake in describing ROCE.  In my defense, I dont exactly calculate ROCE and merely use the numbers from screens.
ROCE = EBIT(1-Tax Rate)/ Total Assets and not EBITDA as mentioned before.

Does someone want to have a crack at this? I see issues whenever you use EBITDA without understanding maintenance capex. Please read this: Placing EBITDA into Perspective

More on WMT: A reader posted this in the comment section:    Does that article even touch upon the ture nature of WMT’s competitive advantage?  No wonder the obvious is overlooked.

What Is Behind The Numbers?


With sentiment high and stocks in general having rallied for five years, be very careful about the financial numbers in your companies. A strong review of financial shenanigans is worth your time.

John Del Vecchio and Tom Jacobs, the authors of What’s Behind the Numbers?, are giving a presentation at the New York Society of Analysts. See sample chapter:WBTN_DelJacobs_samplechapter

Attendees will learn:

  1. How companies hide poor earnings quality
  2. Repeatable methods for uncovering what companies don’t tell you about their numbers
  3. Reliable formulas for determining when a stock will get hit

Whether you’re a number cruncher or just curious, you’ll greatly benefit from this seminar, given by two people who combine investment chops with crowd-pleasing stories. So what are you waiting for?

Date: January 13, 2014
Time: 6:30 – 8 pm
Place: NYSSA Conference Center
1540 Broadway, Suite 1010
(entrance on 45th Street)
New York, NY 10036
Price: Nonmember $55 ($10 surcharge for walk-ins)

Advance registration is encouraged in order to avoid the additional charge for walk-ins. Also, space is limited by the size of the room.

The above video is worth viewing. Just remember that the authors do not understand the causes of inflation, but you will learn more about individual investor psychology. Jacobs provides plenty of excellent advice for individuals in terms of search and strategy. Go small and look for wholesale emotional selling.

If you don’t want to invest in stocks, then go here: