I used to think of accountants as some of the dullest people on earth. I pictured them sitting in their office alone, muttering in a monotone voice as they counted invoices and occasionally frowning when they discovered a 10-cent discrepancy in their ledger. But then I read 'Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports.' Today, I think of some of them as creative geniuses.
Many accounting shenanigans detailed in the book take advantage of the accrual basis of income statements. Accrual accounting registers a sale when a company expects to get paid, regardless of whether the cash has arrived. This rule makes sense - if a landscaping company performs a service for Bell Canada and bills them for it, the contract stipulates that the landscaping company now owns the cash; Bell is just holding it temporarily. A fraudulent landscaping company, however, could send Bell a larger bill than warranted and book the increased amount as sales despite knowing that Bell would only pay a fraction.
Expenditures are also vulnerable to manipulation. One common fraud 'capitalizes' expenses - it spreads expenses over several years, reducing this year's expenses and inflating earnings. A landscaping company could, for example, spread out its $2,000 advertising cost over four years for $500 per year instead of expensing all of it this year.
Not all accounting manipulations are illegal. Because every business is different, a rigid set of accounting rules can't suit every business. The rules, therefore, contain some flexibility, and companies have unsurprisingly leveraged them to paint the most flattering pictures. Investors, however, are not pleased. Warren Buffett once called it 'one of the shames of capitalism.'
If a company manipulates its earnings, its P/E and EV/EBIT ratios become unreliable. Professional investors often compensate by looking at a company's Enterprise Value to Free Cash Flow (EV/FCF) ratio, defined as follows.
shareholder_financing = price_per_share * number_of_shares_outstanding lender_financing = sum(all_debt) enterprise_value = shareholder_financing + lender_financing - cash free_cash_flow = profit_after_tax + depreciation - capital_expenditures - changes_in_working_capital ev_fcf = enterprise_value / free_cash_flow
Conceptually, free cash flow represents profits calculated on a cash basis instead of an accrual basis. On a cash basis, the landscaping company would only record sales after receiving the cash from Bell and expense all of the advertising costs this year. Investors often treat EV/FCF as a more truthful version of EV/EBIT.
However, the EV/FCF ratio is not perfect either. There's a good reason why accounting standards work on an accrual basis. The timing of cash flows can be erratic, so a company's EV/FCF can swing wildly from year to year. If a stock looks good from an EV/FCF perspective, investors must wonder if it's because business has been good or because more cash just happened to flow in this year. Free cash flows are not immune to manipulation either. Companies can stiff suppliers, for example, to temporarily increase their cash flows.
We can cover some of EV/FCF's imperfections by taking the average of free cash flows across multiple years. This remedy, however, presents new problems by giving weight to old data that may no longer be relevant.
Do the advantages of using free cash flow outweigh the disadvantages? The data is inconclusive. While investment strategies based on EV/FCF have outperformed those based on P/E, most of the data I've examined puts EV/FCF neck and neck with EV/EBIT.
EV/FCF and EV/EBIT have strengths and weaknesses that derive from different accounting bases. Rather than favouring one, it's better to look at both.
EDDY WEALTH