What You See Is What You Get

Back to the discussion of understandable accounting.

So, it is 1933. You are Congress. You want to give investors all of the information that they need to make informed decisions on buying and selling securities. What material would you require companies to make public? Obviously their locations, goods and services sold, brands, management, history, and the like. But, in the end, everything comes down to numbers. The investor has to decide what is a fair price in dollars for a stock or bond. So, investors must have financial information in dollars.

Which raises the question of what financial information is relevant to investors’ — and therefore to the markets’ — pricing decisions. This is the fundamental question of corporate finance: what is value? More below.

Most believe that the value of a business is roughly related to the present value of the cash that is rationally-estimated to be generated by the business. There is some debate about how rational these estimates are, but pretty much everybody thinks expected cash is a good start in valuing a business.

Under this analysis, investors need info on cash to be generated by the business. Unfortunately, that is easier said than done. Current cashflow may not be prophetic. Businesses can borrow and generate cash — but, in this case, today’s cash inflow is tomorrow’s payment, with no net cash generated. (As I noted in a comment to a comment on an earlier post, this was Enron’s biggest scam: disguising borrowing as operating cashflow). An asset can be sold for a loss and generate cash, but that does not bold well for the future prospects of the business. Employees can be paid with stock or stock options. And so on…

So, investors need a lot of financial information. But the goal is to guess future free cash. This requires judgment, not bean counting. Nevertheless, Congress and the SEC left this key judgment — the heart of the modern public capital markets — to the beancouters. Tomorrow!

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