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There is a tendency in finance to treat Generally Accepted Accounting Principles with a whiff of contempt. Sure, GAAP numbers are sacred whenever a company invents a goofy name for "Contribution Profit," i.e. the amount they make when they sell an incremental whatever-it-is-that-they-sell, or when a chain reports "four-wall profit," i.e. the profitability of individual stores without accounting for corporate costs, brand advertising, financing charges, etc., it's fine; but when Groupon talks about "adjusted CSOI" or WeWork brings up "Community-adjusted EBITDA," it's the end of the world.¹ But that negative attitude towards weird metrics is partly because institutional investors are mostly looking at companies through the lens of cash flows, not GAAP earnings.

There are good reasons for this. First, GAAP earnings are imperfect. Some companies depreciate faster than they need to, and from a tax perspective, that's great! And some businesses collect cash from customers faster than they disburse it, which means that incremental sales reduce how much working capital they need. A business like Costco, for example, requires negative cash to hold inventory, because it's sold before the invoice comes due. For other businesses, like retailers and restaurants who own all of their locations, growth soaks up cash upfront and then produces a stream of cash flows later on.

In the very long term, GAAP accounting and cash returns sum to the same amount, because in the very long run a company gets liquidated, either by itself or by whoever buys it. It's not really possible to produce a set of income statements, cash flow statements, and balance sheets that don't cause cumulative free cash flow to add up to net income, because the last balance sheet produced shows $0 for every asset and liability, and liquidating an asset for an amount other than what was on the books requires taking a writeup or writedown.

All of which makes sense, because GAAP is an accrual accounting system, and accrual accounting just means recognizing future cash inflows or outflows once they're sufficiently likely to happen, not when they happen. In a perfect accounting system (to be clear, no such system exists, but we try to get closer all the time) the only difference should be the time value of money, and in theory an accounting system could deal with this, too; you could discount your receivable based on the time value of money and the risk of nonpayment, and then continuously recognize revenue as it got closer to being paid.

There's room for a wide wedge between the accounting value of assets on the balance sheet (i.e. the cumulative sum of capital raised and profits earned less money returned to shareholders), and the economic value of those assets (in terms of the net present value of the future cash flows they generate). In some cases, this is because accounting rules are conservative, and regulators don't want companies booking gains because of well-timed inventory purchases or because they bought their headquarters building when real estate was cheap.² There's room for a gap in the opposite direction, too, when a company is ostensibly earning lots of money but is burning through some scarce off-balance-sheet resource; in accounting terms, a company that is good at selling products that don't work might be profitable, but in economic terms their biggest initial intangible asset was that nobody had heard of them, and every sale diminishes that asset until it runs out.

What fundamental analysts typically do is create a sort of Specifically Accepted Accounting Standards for each company and industry, where they figure out 1) in what kind of increment does the company spend its capital, and 2) what's the return on that investment? Some of these can be done on the basis of unit economics—an enterprise software company might spend $20k per customer on contracts that ultimately return a net profit of $50k. But some of it's harder to calculate: what's the ROI of one more software engineer, or one more data scientist? The best you can get is to assume this is roughly a function of revenue, and to treat this overhead as an otherwise semi-fixed cost. This is a form of accrual accounting, in its own way, where a company gets evaluated by looking at how much future cash flow its current actions generate.

Crucially, while this kind of modeling uses cash flow as an input, it doesn't blindly extrapolate it. Some companies can achieve higher free cash flow than GAAP earnings for a while by reducing their working capital needs, but this tends to get harder to execute over time. And suppliers might be persuaded to get paid in 60 days rather than 30, but at some point—90? 180? 365?—they'll say no, and at that point future cash flow growth gets more correlated with future earnings.³

Analysts don't think of themselves as accountants, and given the gap between how analysts and accountants think about the value of companies, that's not going to change. But analysts really are accountants, just accountants who prefer to develop their own rules for each company. These rules will almost never map perfectly to GAAP, but they’re ultimately efforts to extend accounting to whatever limit makes it easiest to understand what a given business is really worth.

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Read More in The Diff

Accounting is an implicit thread running through many Diff pieces: we’re always trying to understand what really makes a company tick.

• We’ve looked at the puzzle of why companies own their headquarters building.

• Some real estate companies are really in the business of flipping land; we’ve looked at that for US homebuilders ($) and for China Evergrande ($).

• One of the first groups of companies to persuade people that alternative metrics were better is the Liberty Media complex ($).

• And here’s our cross-examination of various valuation tools.

1. To be fair, both of these investments did terribly in the period after they got ripped on for these metrics. But that didn't happen because WeWork disclosed the contribution margin of opening another location—it happened because that contribution margin wasn't high enough to justify their overhead!

2. Among other things, giving companies freedom to do this encourages them to buy more real estate, which will tend to slowly appreciate over time, and to delay writing it up until their operating earnings are lagging. Companies do this kind of thing anyway by selling their real estate, but selling has transaction costs, especially if you insist on closing the deal by the end of a calendar quarter—when you say "... by June 30th," your counterparty will smell blood in the water. So this amounts to a tax on faking financial health and stability. But in general, taxing negative-sum activities is a good thing, so this system actually works out quite well.

3. There are also some roll-up strategies that rely heavily on this kind of working capital management, but it eventually peters out once they've made all the good acquisitions they can or once they're big enough that they set an industry standard everyone else follows.

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