Your potential alpha is not where the map differs from region. This is where the map differs from the region And Where other investors are abusing that map.
Continuing in terms of the previous memo, let’s examine the balance sheet.
Calculating the entire balance sheet
Equity and debt investors are the most common source of capital, but they are not the only ones.
Warren Buffett introduced the idea of insurance floats to many investors – the advance cash is collected from customers which is equivalent to 0%. Similarly, insurers are estimating the acquisition cost and default rate of this 0% semi-.
You can extend Buffett’s thinking to categorize each balance sheet line item by representative relationships: customers, suppliers, employees, investors, and government.
Balance sheet classification by relationship
If you identify these floating sources as 0% loans, then you should analyze them with the mindset of an investor. These semi-loans can be useful or risky depending on their credit, maturity and liquidity profile. For example, financing through payable accounts was a cheap source of capital for Costco but a source of trouble for some factor finance firms.
Inventory and fixed assets do not fit into this semi-loan mold. These are more closely related to the original call options. A company buys inventory with the expectation that this original option will run out of money – that future customers will buy the product. Suppliers generally have no obligation to repay cash if the listing is not sold, so it is not a semi-loan. Fixed assets work the same way. It’s a fun intellectual exercise to model writeoff, devaluation, and loss as a loss of these real alternatives, but so far I haven’t found it as a material source of alpha.
Capital cost reconsideration may be more useful.
All liabilities of the WACC should be included
Capital expenditure is a weak concept. Charlie Munger jokingly calls it a “totally amazing mental error.”
Different people have different capital sources and opportunity costs. Why do we think every investor should use the same discount rate? Moreover, the cost of a company’s capital depends on the company level and the macro level. Why do we project a stable discount rate without imitating many possible paths for capital expenditure?
But if we insist on using this formula, we should at least calculate the capital sources that companies tap. To begin with, here is the current definition of the weighted average cost of capital (WACC):
Weighted average cost of capital (current definition)
The endangered WACC is limited to the capital provided to investors. It should really be expanded to include non-investor capital sources highlighted in blue below.
The cost of capital should include all liabilities
The two companies may have the same traditional WACC debt debt and equity from investors only কিন্তু but when 0% semi-loans are included, there can be a cheap true cost of capital.
Non-investing capital sources have their own attractive subtleties.
Employees and government funding are suspended expenditures, so they are not actual capital flows. However, they are quite useful for large corporations to maintain stable cash-flow streams. Berkshire Hathaway’s ballooning delayed tax liability is a prime example here.
Customer and supplier financing is a source of new capital. In this situation, customers pay ahead of time and suppliers send the list to a company before they need to pay. Examples of customer financing include the Kickstarter project, Tesla’s $ 14 billion Model 3 pre-sale and annual deals at SaaS. Some examples of supplier financing are Walmart guaranteeing their payment term from net 20 to net to0 and small merchants guarantee inventory availability in the group’s marketplace.
This broad WACC can be an alpha opportunity when a company has an unconventional capital source and, more importantly, when that source can significantly change the overall cost of a company’s capital.
Market value of equity
When Luca Pacioli coded double-entry accounting in 1494, publicly traded stocks did not exist.
Perhaps this is why the initial accounting standard was not created to update the balance sheet based on fair market value. Why pay attention to quotes in the stock market when there was no stock market to focus on?
To date, GAAP accounting only tracks equity book value at historical historical costs – contributed capital and maintains earnings after taxes and dividends. If the stock market value is higher or lower than the book value, this new valuation is not included in the company’s accounting.
The problem is that companies continue to trade in their own equity after going public. In fact, making it easier to trade in their own equity The The whole point of going public. A public company should have less difficulty selling equity to outside investors, providing equity compensation to employees, and buying equity from the market. How can investors track these transactions if they are not fully reported?
The way to fix this is to add a GAAP line item to the market value of the equity.
Adding a line item for equity market value
To avoid controversy between historical costs and fair price measurements, we can add new mark-to-market line items to the balance sheet. We can report mark-to-market changes separately from operating income. This approach will avoid hassle in the income statement and respond to Buffett’s criticism of ASC 321.
Investors are already indirectly doing this. Popular metrics such as enterprise value and queue ratio effectively identify equity with share market value. Directly tracking the fair market value of equity will make it clear which companies are intelligent dealers in their own equity and which are weakening their weaknesses.
Accurately calculate share-based vibrations
This new line item for equity market value will allow us to accurately measure share-based compensation (SBC). As it stands today, we do not identify SBC in the market.
How share-based compensation is currently practiced
When SBC is first granted, an appraiser comes up with a low equity appraisal that gives the employee an optimal tax treatment. We need to fix wage costs for current equity prices when employees use their options.
The lack of clarity about identifying equities in the market and SBC creates significant potential for Alpha. Screening for capital allocation is already challenging – return of issued shares, return of repurchased shares and the structure of the acquisition agreement. But the most important capital allocation metric is even more opaque – the return on hired staff. At the moment, it can be difficult for investors to see which of the teams they have created is earning the most.
Alpha Opportunity is to find entrepreneurs who are world class capital allocators and insufficient for this. Think Great: Henry Singleton is issuing highly valued Teledin equity for M&A and then buying shares cheaply in the 1970s and 1980s. John Malone is paying 6x EBITDA (post-cost synergy) as cash and debt to integrate small cable operators into TCI. Mark Leonard is adding niche vertical software products to the constellation software portfolio.
An early search among these capital allocators would have made an investor’s career. In a decade, we can look back at the most charismatic team builders in the same light.
Possibility of network-based accounting
The strategies in this series are a sample of how you can create alpha from GAAP that is being explained today. How you use them depends on your strategy, whether you are a long time investor, a short seller or an entrepreneur.
Alpha-generating accounting opportunities
How long these alpha opportunities will last depends on how GAAP and basic investment strategies evolve over time. Double-entry accounting was created with pen and paper. Computers can form the basis of GAAP and investment analysis.
In plain English, business is about relationships. Double-entry accounting helps us track those relationships, but currently every company in GAAP has reports that it is an individual entity. We want an easy way to look at all those relationships at once.
You can call it that Network based accounting.
Agreements are the legal markers of the relationship between business entities. In the words of Nobel laureate Oliver Hart, these are “connective tissues in the modern economy.” With an updated structure, we can graph contract networks between companies. This method was not possible in the pre-computing era and is rarely practical today with our current data standards. GAAP renewals for the computing era will make these relationship models effective.
I think the future of accounting lies in agent-based modeling. We can consider companies as individual agents to mimic how they interact now and how they may interact in the future. You will be able to see each company’s network of relationships with customers, employees, suppliers, investors, competitors, government and the public. Some of these relationships have just been mentioned in our current GAAP model.
Dozens of hard-working questions will be easier to answer through network-based accounting.
Does a company have a long-term or short-term customer relationship? Have the company’s suppliers started offering interest-free financing? Can its investors be forced to sell suddenly? And scary: are there any infectious risks that could threaten the company’s core relationship network?
The capital market can be much more efficient, if this structure can be properly abstracted into software. But for now, it’s a fun conversation after work.
Today, I am more interested in alpha that we can create with the market because they are currently structural. And I think the way investors respond to GAAP and GAAP reports will create significant opportunities in the long run.
Thanks to Tom King, Nadov Manham, Ben Reinhardt, Kevin Shin and Slater Stitch for helping with these memos.
You can read more from Luke Constable Librays Capital Library.
If you liked this post, be sure to subscribe Entrepreneurial investors.
All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.
Photo credit: Grandzian, Martin / Wikimedia
Professional education for CFA Institute members
Members of the CFA Institute have the ability to earn self-assessment and self-reporting professional education (PL) credit, including content Entrepreneurial investors. Members can easily record credit using their online PL tracker.