Accounting is More Interesting Than You Thought

Important things come in packs of four- the Four Horsemen of the Apocalypse; four Teenage Mutant Ninja Turtles; Jerry, Elaine, George, and Kramer in Seinfeld; and the Fabulous Four Beatles. 

The world of accounting is no different, you have the balance sheet, income statement, cash flows, and notes to the financial statements. In this blog, we are going to learn how to use simple accounting to value companies.

Balance Sheet: The George of Accounting

Like George Harrison, the balance sheet is the quietest of the financial statements. It doesn't say much at the press conferences.

He was the guy alone in the corner of the nightclub obsessing over guitar riffs. He preferred to be removed from the limelight, yet his impact on the band was immense.

The balance sheet is a photo of what the company owns and owes. It does not present the "Twist & Shout" of the income statement or the brute force and presence of the cash flow statements but it tells you a great deal about the underlying value of the company.

It shows how the company is funded and what assets have been acquired with this funding. Buffett looks for something specific in the balance sheet. He looks to see the relationship between total assets and total liabilities.

If a company owns a lot more than it owes, it is not going bust any time soon. Throughout this section, you need to be thinking constantly about the relationship between assets and liabilities. It is going to determine your margin of safety. The mantra is simple: companies with substantially more assets than liabilities will be around for a long time.

Liabilities – The Genesis of All Companies

When companies are born, they need to be funded. They need cash, they need capital and they need it fast.  Without cash, the company will shrivel up and die. 

Companies are funded in two ways – equity and debt. We have already looked at both debt and equity in great depth from an investor’s point of view. We are now going to look at them from the company’s perspective.


On January 1, I start a guitar restoration business where we buy old guitars, restore them to their former glory and sell them at a profit.

To start, we would need cash and/or credit. My first call is to my banker, Slim Shady who is gracious enough to offer me a loan. Slim, who is a musician when he is not ripping off unsuspecting clients, understands guitars and lends me 25,000. I now have 25,000 debt but need more.  I inject 40,000 of my own money and my friend Wayne Kerr invests 20,000 for a 30 percent stake.  I have the remaining 70 percent share. We now have 25,000 of debt, plus 60,000 capital resulting in total liabilities of 85,000. I can now go out and look for axes to buy and refurbish.

This is our balance sheet as at 1 January

Current assets (cash): ​85,000

Equity capital: 60,000

Long-term liabilities: 25,000

In a simple formula: Total Assets = Total Equity + Total Debt

The equity of 60,000 is owed by the company to the stockholders and the debt of 25,000 is owed to the banker. The balance sheet formula can, therefore, be further simplified to:

Total Assets = Total Liabilities

As I get my guitar restoration going, I am going to incur additional liabilities to people other than Mr. Shady and Mr. Kerr. I stumbled across a Gibson SG that I suspect was used by the Beatles and made appearances on Revolver and the White album. It has been sitting in the attic for 30 years and I convince the owner to sell it for $30,000.

I now need to go down "The Long and Winding Road" of fixing up this beautiful ax. These are the additional liabilities that I am likely to incur:

Accounts Payable: I need to change the whammy bar, the pups, and the pots. I go to my local guitar shop and they sell me all the goods for 1,000 and they offer me 45 days to pay. That 1,000 is now registered as an obligation to the shop and is a liability known as an account payable.

Salaries Payable: I hire a local luthier to work with me “Eight Days a Week” on the Gibson and agree to pay him 2,000 per month. That is a debt owed to the luthier and is registered as a salary payable.

Interest Payable: Slim Shady does not lend money for free. The interest rate on the loan is 10 percent which means that in one accounting year I owe him 2,500. That liability of servicing the debt is 2,500.

Income Tax Payable: if at some point in the future I can turn a profit, the taxman will come looking for his pound of flesh.

Customer Deposits: given that guitars used by the Beatles are rarer than good-natured air hostesses when the market hears that I am working on one, there is a line of potential buyers outside my shop. I offer the guitar to the first person to put down a 100,000 deposit. I receive that cash, and put it in my bank account, but it is not mine. I need to reflect that as a liability to the customer. To the rest of the people lining up for the Gibson, I say "Hello Goodbye".

Assets – Putting that Capital to Work through a Hard Day’s Night

The main difference between assets and liabilities is that assets provide a future economic benefit, while liabilities present a future obligation. Let’s simplify this even further – assets put a stream of cash flow into your pocket while liabilities extract a stream of cash flow out of your pocket.

Cash is King

Einstein said, keep it simple and no simpler. The same is true for cash. Cash is the lifeblood of any business, but only keep enough on hand that is absolutely necessary.

With interest rates at record lows and no indication of this changing as the Fed constantly repeats the phrase "longer for lower", the opportunity cost of holding too much cash is high.

One company with a high-quality cash problem is Apple. As of 2020, Apple had total cash of $205 billion which was enough to buy a few small countries and still have change for a football field full of Italian sports cars.  At the same time that Apple was accumulating this tsunami of cash, it started issuing bonds. That begged the question, why didn't they just use their cash?

This cash was not sitting in bank accounts in Cupertino California. It was swigging Guinness and having a good time in Dublin, Ireland. What the hell was it doing in Ireland? I love Ireland. Its matriarch is a hooker moonlighting as a fishmonger (affectionately known as the "tart with a cart"), but Apple borrowing money sounds bonkers.

That cash in Ireland arrived there on account of schemes employed by Apple to avoid paying taxes. Apple set up offshore companies in Ireland, which offered a more favorable tax treatment than the United States. If Apple decided to repatriate this money into the United States, Uncle Sam will tax it quicker than an alcoholic to an open bar. Trump, in his election campaign, urged Apple to repatriate their billions. Apple declined.  This has been made easier given that Trump has never paid his fair share to Uncle Sam.

In my guitar business, I started with 85,000 in cash which is the sum of the debt and the equity capital. I paid 30,000 for the Gibson leaving 55,000 in cash and a bitching guitar "worth" 30,000. The reason I placed "worth" in inverted commas is that this is our first accounting hurdle. Do I register this beautiful beast at the price I paid or "Let it Be" valued at the market price? I paid 30,000 but believe it's worth ten times that. I found a diamond in a pile of rubble. There are two ways to value assets.

Historical Cost versus Mark-to-Market Accounting

Historical cost is the most conservative and records the price paid for the asset.  There are obvious flaws in this approach. That Gibson is worth 300,000 as it is and 500,000 refurbished. If I reflect this asset at 30,000, it is 17 times below the market value. This would understate the value of my company.

Some accountants, therefore, opt for mark-to-market accounting. This would reflect the guitar at the market price. This is also known as fair value accounting. There are, however, shortfalls to this methodology. These shortfalls stem from the volatility or subjectivity in the valuation of the asset.

More on Asset Valuations

Assets that live in transparent and liquid secondary markets are easy to value. If I own Tesla stock, at any time of the day, I know exactly the price of that stock. The price may gyrate more than a motivated stripper on speed, especially when Elon Musk jumps on a video podcast and starts smoking a joint, but on a specific balance sheet date, you can take the closing price and provide an accurate valuation of your Tesla shares.  The same is true with treasury bonds and treasury securities, commodities, and currencies.

Illiquid assets are a bitch to value. Gibsons or real estate, for example, are not traded on an exchange like Tesla stock. Plant and equipment are another example.  Goodwill is also a slippery bugger to value. It is like valuing modern art. George Costanza, in the cult TV show Seinfeld, said he did not understand modern art.

He needs to have it explained to him and then he needs an explanation of the explanation. In 2012, a Mark Rothko painting creatively named "Orange, Red, Yellow", which consisted of three rectangles, of differing sizes and different shades of orange, red and yellow sold for $86.9 million at Christie's in New York.

For me, an uncircumcised art philistine, any kindergarten kid with a box of Crayola and retractable thumbs could have done this.

Goodwill is no different. It is the value placed on a trademark or name.  When Amazon acquired Whole Foods in 2017, it paid $13 billion. Almost 70 percent of this price was allocated to goodwill on the Amazon balance sheet. That means that 70 percent of the cost was allocated to things that are hard to measure, such as the value of the Whole Foods name, potential future growth, and the ability of Jeff Bezos, the Amazon genius, to unlock synergies between his existing business and this new business.

Bezos is a veritable genius, but it is every accountant’s nightmare to value this genius as much as it is to value a Rothko painting.

Impact of Depreciation on Asset Valuations

To complicate the valuation of assets even further, the joker in the pack is depreciation. All fixed assets, except for land, are subject to a gradual loss of value through age and use. This loss of value is known as depreciation. 

Depreciation only affects the value of an asset on the balance sheet. It is added to total expenses and therefore lowers earnings on the income statement. Depreciation is a contra-asset account and reduces the number of depreciable assets.

Annual depreciation is based on the value of the asset (usually taken at cost), its expected life, and salvage or scrap value. Sometimes the country's tax code prescribes the amount that can be depreciated each year – on a straight line or accelerated basis. When investing in assets, pay careful attention to how they are depreciated and for how long they can produce a reliable stream of income.

Other Assets

Prepaid Expenses: A company can pay in advance for a service it is to receive over a specified length of time. For example, I rent a workshop for my guitar business and pay 5,000 in advance for a year's rent. On the balance sheet, I will show this 5,000 as an asset – prepaid rent. Then each month, we would deduct one-twelfth of this amount from the surplus earnings of that month and deduct a corresponding amount from the prepaid rent figure. 

Accounts Receivable: After refurbishing the guitar, I sell it to the customer who deposits 100,000 in my bank account. The sales price is 500,000 and I agree that the buyer can pay me over 4 months in equal monthly installments of 100,000. I will, therefore, record an asset of 400,000 in the accounts payable file of my balance sheet. 

Inventories: Inventory is an accounting term that refers to goods that are in various stages of being made ready for sale, including finished goods (that are available to be sold), work-in-progress (meaning in the process of being made), raw materials (to be used to produce more finished goods). In my example, my inventory management is simple. It is one supremely awesome, kick-ass guitar with a historical cost of 30,000 and is a work in progress as I restore her to her former beauty.  Inventory is generally the largest current asset – as is the case in my example.

To ensure all accounting records are up-to-date and accurate, businesses manually take an inventory count at the end of each accounting period, which is typically quarterly or annually. Companies that do a daily inventory count take perpetual inventory and their count is always current. Any difference discovered between the inventory count on the company’s balance sheet and what actually on hand is called “shrinkage.” It is the inventory that is missing, for whatever reason. Sometimes the inventory is lost, other times it is stolen by sticky-fingered scumbags.

Conventional wisdom on inventories is that large inventories are a bad thing. In the 1980s, the Japanese automakers coined just-in-time manufacturing which aimed to limit the time a motor vehicle would spend between leaving the factory floor and hitting Route 66. The objective was to keep inventories small.

The world of inventories, however, is not black and white. Inventory is an asset, and the more assets you have the better. However, large or growing inventories can sometimes create challenges of their own. Inventories need to be financed, and sometimes they require large bank borrowings, or else they suck up large volumes of company cash.

When looking at inventory, the key metric is inventory turnover. My first investment banking client in South Africa was a wholesaler. His motto (better said with a strong South African accent) has been indelibly burned into my brain: “stack them high, price them low, and let them go”.

Quick warning on inventories: When companies are desperate to stay afloat, inventory fraud is the easiest way to produce instant profits and dress up the balance sheet. Assume that you have a million pairs of sneakers located in ten different warehouses scattered around the country. Do you really think that the auditors are going to physically inspect every single pair of sneakers? Hell no. They will first send their most junior team of auditors to take a gander and draw a conclusion based on a sample of sneakers. In the course of history, human beings have displayed exceptional creativity in massaging inventory numbers.

Retained Earnings - Linking the Balance Sheet and the Income Statement

This is a balance sheet item but it is not an asset. It exists in the capital or equity account of the balance sheet and is an amount owed to shareholders. This is the bridge between the income statement and the balance sheet.

In my guitar business, after the first sale, we dedicated the rest of the year to surfing, riding, and smoking large quantities of the perfectly legal devil's lettuce.

We sold the guitar for a mind-altering profit of 470,000. After all expenses and taxes, we were left with 400,000 in profit and we have now faced an important decision. Do we pay a portion of this 400,000 out in dividends, or do we reinvest the money in the business?

We are unanimous in selecting the latter option. There is no profit distribution and the 400,000 gets reported to the capital account as retained earnings.

Dividends are paid out when the company has no better use for the cash. Although I started the business slowly with only one deal, it will not be difficult for me to put the cash to use and find other guitars. The world is full of "Fools on the Hill" who have valuable guitars hidden in their attics. 

One company that has never paid a dividend since Buffett took over is Berkshire Hathaway. For the financial year ended 2018, the company generated $321 billion in retained income – no other company in the world came even close to this. No dividend was paid and that money was plowed back into the business to be used in Buffett's next major acquisition. The day that Berkshire pays a dividend is the day you mourn the loss of the world’s greatest investor.

So What can we do with this New Found Knowledge?

We can now calculate the book value or accounting value of a company.  Book value is the amount that would be raised if the company was liquidated in the short term. It would involve selling all the assets, settling all the debts and whatever is leftover is known as the book value.  For listed shares, you can take the total book value and divide that by the number of shares in circulation.  Analysts then compare this book value per share with the market price per share.

The book value is the value assigned to the company by the financial statements. The market value is the value assigned by the market via the stock price.

This goes back to the fundamental principle that the company and the stock are two different things. It is possible to have good companies that are bad stocks and bad companies that are good stocks. I know this makes no sense. I might as well just say:  "Yellow matter custard, dripping from a dead dog's eye, Crabalocker fishwife, pornographic priestess, Boy, you've been a naughty girl, You let your knickers down”.  But it is not that difficult to understand.

You need to separate the company from the stock. They are not the same thing. In this example, the book value is the company, and the market value is the stock. This will become clearer with the example below, where we look at Goldman Sachs, the "Sun King" of investment banks.

Calculating the Book Value of Goldman Sachs

Below is the balance sheet for the fiscal year ending in 2018 according to the bank's annual 10K statement.  Goldman Sachs has a December year-end.

Total Assets: $931 billion

Total Liabilities: $841 billion

The book value was $90 billion ($931 billion minus $841 billion) at the end of 2018.

In theory, if Goldman Sachs liquidated all of its assets and paid down its liabilities, the bank would have roughly $90 billion left over to pay shareholders.

Market Value of Goldman Sachs

The market value is the value of a company according to the financial markets. The market value of a company is calculated by multiplying the current stock price by the number of outstanding shares that are trading in the market.

Market value is also known as market capitalization. As of the end of 2018, Goldman Sachs had approximately 367 million shares outstanding while the stock traded at $167, making Goldman’s market value or market capitalization approximately $61 billion. 

We now have the accounting value of the company and the market value of the stock. “Here Comes the Sun”. Goldman Sachs’ liquidation value is $90 billion but the market was valuing the bank at $61 billion. The stock was trading $29 billion below its accounting value at the end of 2018 which meant that it was undervalued by almost one-third.

Goldman Sachs was trading at 0.67 times the price to book at the end of 2018. As of November 2019, the stock had gained 40 percent and was trading at parity with its book value. 

To show you just how out of favor banks were at the end of 2008 – three months into the financial crisis, Goldman Sachs was trading well below its book value – at 0.5 times. 

According to data from Bloomberg, 558 U.S. banks were trading below book value at the end of 2008.  The worst was Wachovia which was trading at a price-to-book value of 0.29 and was later snapped up by Wells Fargo. Only 277 were trading above their book value. Wells Fargo was the most favorably valued amongst the big banks with a price to book of 2.11 – which explains why the government forced them (Wells Fargo) to buy the flailing Wachovia.

Two Important Health Warnings About Balance Sheets

“Do you want to know a secret?”  Human beings, at times, on rare occasions, have been known to be lying, cheating, and dishonest bastards. You need to keep this in mind when reading a company balance sheet. 

1) Question Everything

A father teaches his ten-year-old son about trust. He instructs him to climb to the top of the roof of the house and jump. The terrified son protests. The father assures him that he will catch him. The son jumps nervously.  A few meters from the ground, the father moves away, and the kid javelins into the garden lawn. The tearful son looks up at the father and asks why he did not hold true to his word. The father replied that in life, you should trust no one. You should never trust a balance sheet and you should be on the lookout for a fake smile.

French physician Guillaume Duchenne discovered that when you smile, there are two kinds of muscles activated in your face. In genuine or "Duchenne" smiles, one type of muscle is responsible for enlarging your cheeks and exposing only the top row of teeth.

Crow's feet, which are wrinkles etched in the corner of the eye, will be visible. Also, your eyes will be partially closed and your pupils will dilate to indicate interest or arousal.  You will be able to tell a fake smile from the absence of the crow's feet, eyes wide open and exposure of the lower row of teeth. The balance sheet is a snapshot of what the company owns in assets and owes to debtholders and equity holders at a specific point in time. Lying, cheating, and deceiving companies will overstate their assets and understate their liabilities.  You need to be on the lookout for fake smiles.

2)  Do not get Blinded by Accounting

Thinking that accounting and finance are the same things is like thinking that jam and jelly are the same. Combine some crushed-up or puréed fruit with sugar and perform a little cooking magic and you'll end up with jam. Jelly, however, uses fruit juice instead of whole fruit pieces.

Accounting helps a business understand its current financial position. All financial statements are based on money received and lost during a set period. On the other hand, finance aims to forecast the performance of a company into the future. A financier will analyze the best investments and choices that will bring success down the line.

It can be dangerous to apply accounting definitions in the real world of finance. Accounting defines an asset as something that is owned and a liability as something that is owed. This can be problematic. Robert Kiyosaki defines an asset as something that puts money in your pocket, and a liability is something that takes money out of your pocket.

Is Your Yellow Submarine an Asset?

Differentiating between an asset and a liability is not always easy.  We are taught that the house (or a yellow submarine converted into a house) in which we live is an asset and it is reflected as such on our personal balance sheet.

The house in which you live is actually a liability based on the Kiyosaki definition. It takes money out of your pocket by way of taxes, levies, and interest if the house is mortgaged. If you are in the business of flipping houses, it is an asset because it represents inventory in your business. 

You may argue that the house in which you lay your head at night is an asset because it could appreciate in value. Here the operative word is “could” appreciate.

House prices do not always go up. The buyers of Miami condos in 2007 were testimony to this in 2009.  Property speculation is a risky business and not everyone comes out a winner.

Another financial fallacy is that your car is an asset. Unless you are an expert collector of vintage cars like Jay Leno, there is as much chance of your car being an asset as my lumberjack friend Roger from Essex winning the Nobel Prize for chemistry.

When you buy a new car, it loses 20-30 percent of its value the moment the front tires touch the first section of asphalt outside the dealership and that is just your first cash "outflow". Add to that insurance, taxes, licenses, financing, services, fines, parking, and fuel.

The reason why Uber is so successful is that people are starting to calculate the total cost of car ownership. Marketing propaganda from Uber claims that commuters who do less than 15,000 km per year are better off using a ride-hailing service than buying a car.

Income Statement: The John of Accounting

The income statement is the volatile genius of financial statements. This is where the magic happens. It is here that income is registered and where the great beauty of the allowable tax deductions will be seen.

During his days with the Beatles, Lennon was a devout Monopoly player. He had his own Monopoly set and often played in his hotel room or on planes. He liked to stand up when he threw the dice, and he was crazy about the properties of Boardwalk and Park Place. He didn't even care if he lost the game, as long as he had Boardwalk and Park Place in his possession. Everyone knows that Monopoly is about acquiring high-quality properties and then sitting back and collecting the rent.

If the balance sheet provides a photograph, the income statement is a movie of all that has been generated over the period. Revenue, also known as the top line, is total income. It is the total amount the business has invoiced over the period. In the case of my guitar-flipping business, it is the income we have earned from the guitar(s) we have flipped.

For the financial year ending January 2019, Walmart generated over $500 billion making it the world's largest company by revenue.  Coming in second, was China Petroleum with $442 billion. More than 100 million Americans shop at Wal-Mart every week.

The founder of Walmart, Sam Walton was an eccentric. Wal-Mart's head office is in the thumping, grinding state of Arkansas. Arkansas is home to another famous human being, William Clinton.

There is a story of Sam Walton and two Wall Street bankers. The bankers were flying into Arkansas to meet with Sam. Sam told his assistant that there was no need for them to take a taxi from the airport – and that he would pick them up. Imagine the surprise when you hear that one of the world's richest men is going to give you a ride from the airport. Wall Street bankers are fueled with high-octane egos. For these two bankers, this was rocket fuel. It was like two pimply teenage kids growing up in the 80s being invited on a date with Bo Derek.

Sam pulled into the airport in his single-seater pick-up truck accompanied by his 50kg Great Dane. He met the bankers at the exit of the airport and walked towards the pick-up. As the one banker leaned forward to open the passenger door, Sam looked up and said: "No, no. The dog rides in front with me, you guys are in the back". This was Sam's way of reminding the bankers that in Arkansas, he made the rules.

Walmart is a high-turnover retailer. After the turnover, we need to take into account the cost of all those tube socks and flip-flops sold. After deducting the cost of goods sold, we are left with the operating income. We then add back any additional income that was earned. 

Analysts argue that Wal-Mart is not a retail company – it is a financial services company. The goods that they sell on day one only need to be paid for at some time in the future. Wal-Mart is well known for negotiating tough terms with its suppliers where they pay in a couple of weeks or in a couple of months. The time between selling the goods and paying the supplier is the time in which Walmart can invest that free money.

In the financial year ending January 2019, Wal-Mart earned other income of $4 billion. Having added other income, we are left with total income.

Tax Deductions - The Sweetest Two Words in the English Language

Now we get to the part of the income statement that makes running a business so sexy – the deductible expenses. The tax code is designed to encourage entrepreneurship – to encourage young Sam Waltons to forge out on their own, start their own businesses, and employ people, and aspire to humiliate Wall Street bankers.

The most commonly allowed deductions are expenses incurred in the production of income, including but not limited to rent, interest, travel expenses, wages and salaries, bonuses, telephone expenses, etc. After these deductions, we are left with net income on which tax is payable. The objective of any business is to get your net income as low as possible to reduce the amount of tax payable.

Getting to the Bottom Line

How do we get from the top line to the bottom line? We mentioned revenue (which is the top line) and then tax deductions. There are, however, a few other lines in the income statement. I will hold your hand through these additional lines.  The first line below revenue is the cost of goods and services. 

Walmart in the financial year ending January 2019, earned revenue of $514 billion. The cost of the goods and services sold to generate this revenue was $385 billion which lead to a gross profit of $128 billion.  The company then posted operating expenses of $107 billion. After deducting these operating expenses, you are left with an operating income of $22 billion. That is how we get to the bottom line.  Let's now see how we can use this as a "Ticket to Ride" the bus of heightened financial knowledge and awareness.

Price to Earnings Ratio

In the George Harrison section of this chapter, we used our newly found knowledge of the balance sheet to value a company in terms of the relationship between the price of the stock and the book value or accounting value.

I trust you are noting the trend that is developing. The company and the stock are two separate entities. They are not the same thing. This lies at the core of Buffett's value investing. The Buffett mantra is that price is what you pay, and value is what you get. The objective is to pay 5 for a company that is worth a lot more than 5. A stock market is a place where everyone knows the price but no one knows the value. The reason why I am spending so much time on accounting is that the financial statements of a company are the window to the value of the company.

When we calculated the price to book, we recognized the weakness of this calculation.  The book value is the liquidation value of the company. If we did a fire-sale of all the assets and paid off all the liabilities, what we are left with is the book value which is also known as the accounting value. The problem with the book value is that assets are difficult to value and secondly the balance sheet does not value the employees of the company. It also contains bullshit assets like goodwill.

So how can we improve on the limitations of the price to book valuations? We could take the price per share of the stock and divide it by some income statement item because the income statement shows the revenue generation capacity of the corporation.  The most commonly used metric is the net income of the company for a given period and divides that by the number of shares in issue.  This calculates how much the company earned per share. Then you take the price of the share and divide that by the earnings per share and this will give you the famous price: earnings (P: E) ratio.

Exxon Mobil Example

Exxon generated a total net income of $21 billion for the financial year ending December 2018. On the same date, the company had 4.2 billion shares outstanding. 

In 2018, Exxon earned net income of approximately $5 per share ($21 billion divided by 4.2 billion shares). Exxon shares closed the year in 2018 at $68. This translates into a price-to-earnings ratio (P:E ratio) of 14 times (68 divided by 5).

How could you explain a P:E ratio to your grandmother? If you bought Exxon shares at the end of 2018, you were paying 14 times earnings. If Exxon maintains the same earnings for the next fourteen years, you will recover the $68 spent on the share with accrued earnings. Every year, the company will “pay” you $5 per share. That net income belongs to you but you will not physically receive it. It will be reinvested into the company on your behalf. After 14 years, you would have recovered the $68 paid.

Are fourteen years a long time or a short time? Finance is a relative game. Price-earnings ratios are neither high nor low, they are higher or lower. Amazon is trading at an 80 times multiple which is higher than Exxon Mobil. Exxon and Amazon are two different animals.

You would have noticed the phrase: "if Exxon maintains these earnings for the next fourteen years". One would hope that Exxon could earn more than $5 in 2019 and into the future and this would reduce the time over which you will recover the price paid.

Amazon is a faster grower than Exxon. E-commerce, cloud computing, and video streaming are growing faster than fossil fuels. Even though you are paying an 80 times multiple for Amazon, if they can duplicate their earnings every couple of years, investors in 2019 may recover the price paid for the stock in less than fourteen years.

Cash Flows Statement: The Paul of Accounting

The cash flow statement is the real deal. You can manipulate asset values (Enron), and revenue numbers can be inflated (Enron) but cash entering or leaving a banking account is as real as it gets.

Cash is the lifeblood of the business – without cash, the business cannot survive. It is humble and honest, and at the same time, it is the very essence of why businesses are started.

Cash is the Paul McCartney of financial statements. As of 2019, according to Forbes, McCartney was the world's richest rock star with a fortune valued at $1.2 billion. This man knows how to manage his pennies.

Paul versus John

The public breakup of the relationship between Paul and John is well documented. They did not speak for years and would only communicate through lawyers. In the same way, the income statement often does not see eye-to-eye with the cash flows.

The income statement records income on an accrual basis. If your tax year ends in February 2019, and on the last day of February you close a big sale, that revenue will be recorded for the tax/financial year ending February 2019. The cash will only be collected in the tax year ending February 2020.  Cash is not recorded on an accrual basis. If cash does not hit the bank account within the financial year, it has to have to be recorded in the following year.

You need to pay close attention to how much cash the business is generating. The cash flow statement is divided into three segments. The first is the cash flow generated from operating activities. If cash flow is the John McCartney of financial statements, cash flow from operating activities is the "She Loves You" – the best-selling Beatles song ever -  of the cash flow statement.

Cash Flow from Operating Activities

Cash flow from operating activities (CFO – not be confused with the Chief Financial Officer) is an accounting item that indicates the amount of cash a company generates from the ongoing regular business activities, such as manufacturing and selling goods or providing a service. It only captures the cash generated from its core business.

In June 2018, General Electric announced its decision to sell its shareholding in Baker Hughes. When this deal is finalized, this cash will not be recorded in CFO because GE is in the business of aircraft engines, power generation, water processing, and household appliances to medical imaging, business and consumer financing, and industrial products. It is not in the business of buying and selling companies.

Cash Flow from Operating Activities is the sum of net income, non-cash expenses and changes in working capital. Non-cash expenses are the depreciation and/or amortization expenses listed on the firm's income statement.

Because working capital is a component of cash flow from operations, you should be aware that companies can influence cash flow from operating activities by lengthening the time they take to pay the bills (thus preserving their cash), shortening the time it takes to collect what is owed to them (thus accelerating the receipt of cash), and putting off buying inventory (again thus preserving cash).

To understand the divide between the income statement and cash flow from operating activities, it is interesting to compare net income with cash from operating activities. For the financial year ending June 2019, Microsoft reported net income of $39 billion and $52 billion from cash from operations. You could drive a double-articulated truck through this gap.

Warren Buffett does not use book values to calculate the intrinsic value of a company. Instead, he takes the present value of the future cash flows that the company can generate from its balance sheet assets. In our guitar restoration business, our ability to find good quality instruments, fix them up and flip them is not reflected in the balance sheet.

How often have you heard the Chief Executive Officer of a company say that his most important asset is not reflected on the balance sheet? They are referring to the employees who slave like dogs to ensure that they can maintain the luxurious lifestyle to which he has grown accustomed.

The biggest weakness of price-to-book calculations is that the balance sheet does not reflect the value of the employees. Cash flows, on the other hand, reflect the hard work and dedication of these unsung heroes. 

Buffett, if called upon to value my guitar business, would go about it in the following way. He would assess the market in which we operate, he would look at our track record, and project future cash flows out as far as he could and then discount those flows by the risk-free rate. 

Price to Free Cash Flow – an Alternative to Price to Book and Price to Earnings

After each financial statement, we have taken what we have learned and found a way to use this knowledge to value a corporation.

With the balance sheet, we looked at the price-to-book ratios. This was the price per share divided by the book value per share. The book value is also known as the accounting value and is the residual value left if we had to sell all the assets of the company and settle its liabilities. The weakness of this valuation metric is that it does not take into account the future revenue-generative power of the corporation and would undervalue service companies with small asset bases. 

After the income statement segment, we had a look at the price-to-earnings ratio. This takes the price per share of the company and divides it by the net income per share of the company. That ratio defines the number of years that investors would need to wait to recover the price paid for the share through the collection of the annual net income per share earned by the company. The weakness of this metric is that revenue, and therefore net income is reported on an accrued basis.

We now arrive at the cleanest way to value a company, and that is the price to cash flow. Cash landing in the banking account is objective and irrefutable.  Price to cash flow is the price of the stock divided by the cash flow generated by operations per share. Note the tense of generating – it is the past tense.

Investors that are not born with the talent of Buffett, will take the price of the stock and divide it by the cash from operations per share to assess whether the business is under or overvalued.  Purists say that in this calculation, one should use FREE cash flow as opposed to vanilla cash flow. Free cash flow is cash flow from operations minus capital expenditures.

Free cash flow represents the cash a company generates after cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital.

Visa vs Mastercard Example

Visa does 1,700 transactions per second. I would not like to be the person responsible for settling those transactions. It's like single-handedly manning Heathrow's control tower with a hangover the day before a Rolling Stones concert in London. Transactions are dropping like stones into your to-do box and it feels like satisfaction is not a feeling you are going to experience in your lifetime.

We are going to use our key valuation metrics to compare Visa with its biggest competitor MasterCard. Fasten your seatbelt, because this is going to be a “Helter Skelter” ride. You would think that the valuations would be very similar. You could not be more wrong.