Finance
by Baruch Lev and Feng Gu
Do company accounts still work?
Investors once set share prices largely on reported earnings and book value. Baruch Lev and Feng Gu tracked decades of company results and found those numbers explain less and less of what a company is worth. Their book asks why, and what investors should read instead.
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Lev and Gu measure how much of the gap between companies' market values can be explained by earnings and book value. In the 1950s it was most of it. By the 2010s it was far less, even though the accounting rules had grown thicker all the while.
A new factory goes on the balance sheet as an asset. Money spent on research, software, brands and finding customers is written off as a cost. So a company investing heavily in its future looks less profitable than one that isn't investing at all.
A patent granted, a drug passing its trials or a key customer lost can change a company's worth overnight. The accounts barely notice until money changes hands, often years later. By then investors have long since heard the news elsewhere.
Modern reports lean on managers' estimates, such as what an asset would fetch or whether goodwill has lost value. Each estimate adds room for error and for bending the numbers. Lev and Gu argue this has made reported earnings noisier and harder to trust.
Their fix is a new report alongside the accounts, the Strategic Resources and Consequences Report. It shows a company's key resources, what it spends building and protecting them, and what they earn. For an oil company that means its reserves and how fast it replaces them.
Fading use
Company reports explain far less about share prices than they did fifty years ago.
Ideas as costs
Modern firms run on ideas and brands, yet the accounts count money spent building them as a cost.
Guesswork
Reported profits rest more and more on managers' guesses, which makes them less reliable.
Beating forecasts
Investors fuss over whether earnings beat forecasts by a penny, though it tells them little.
What to report
Firms should report the resources that create value, like customer numbers or drugs in testing.
Hot take · true or myth?
News like a patent being granted can leave a company's accounts almost untouched.
True. Accounts record transactions. A granted patent or a successful drug trial barely appears until cash changes hands, so investors learn about it from other sources first.
One thing to try
Pick one company you own or follow. Skip the profit figure and find, in its annual report or investor slides, the measure that shows whether its main resource is growing, such as customers or patents. Compare it with last year's.
Knotd has the key ideas from 250+ non-fiction books, each in a few minutes, in plain words. The End of Accounting comes with a Hot Take round to make it stick.
Get the whole book on KnotdOpen in the appDo company accounts still work? Investors once set share prices largely on reported earnings and book value. Baruch Lev and Feng Gu tracked decades of company results and found those numbers explain less and less of what a company is worth. Their book asks why, and what investors should read instead.
The numbers stopped explaining; Ideas are booked as costs; Big events, no entry; Too many guesses; Report the resources.
Pick one company you own or follow. Skip the profit figure and find, in its annual report or investor slides, the measure that shows whether its main resource is growing, such as customers or patents. Compare it with last year's.
Yes. Knotd has the key ideas from The End of Accounting in a few minutes, in plain words, plus a Hot Take round to test them. It's one of 250+ non-fiction books in the app.
The Intelligent InvestorBenjamin Graham