In a free market, the profit-and-loss system plays an essential role. It signals how resources should be allocated, enabling entrepreneurs to pursue productive avenues and make long-term plans. By the same token, a system of profit and loss identifies those entrepreneurs able to synthesize market information, gather required inputs at a certain cost, and sell the output above that cost. Good entrepreneurs are rewarded with profits while the bad entrepreneurs experience losses and ultimately fail.
However, by adding government intervention, the profit-and-loss system is distorted. In economies with significant intervention, that distortion can be overwhelming, as the signals provided by the profit-and-loss system are entirely drowned out by subsidization, inflation, price controls, artificially low interest rates, cronyism, and fraud.
As the signals become distorted, the results do as well. Capital is allocated to unproductive areas of the economy, political entrepreneurs gain primacy over market entrepreneurs, and the profit-and-loss system is replaced with an increasingly socialistic dynamic comprising central planning, welfare-warfare statism, and the obsolescence of individual productive drive and achievement.
All the Silliness Must Go
As of November 2024, nearly 45 percent—an all-time high, up from 14 percent in 1994—of Russell 2000 stocks generate negative earnings. Since 2014, price-to-earnings ratios for the S&P 500 have ranged between 20x and 30x, compared to the historical average of 16x, implying asset prices have decoupled from fundamentals amid ZIRP and QE. Michael Burry, of “Big Short” fame, tweeted in 2022:
This morning there were still 218 primary stock listings in the United States with a market cap over $1 billion and [earnings] less than NEGATIVE $100 million…29 of them had market caps over $10 billion, totaling $655 billion…
Swaths of the investment management industry, including virtually the entire venture capital (“VC”) segment, make a business out of trading unprofitable companies, slapping progressively higher fiat valuations on them in hopes that a small portion will become objects of speculative fever and earn them enough to offset total losses elsewhere in their portfolio.
This is not advanced probability theory, as many VCs whine. Rather, the industry has abandoned even the pretense of critical business analysis, focusing instead on hype and marketing to pump up portfolio holdings, which they can subsequently offload onto indiscriminate public investors. Doing so has proven remarkably easy in the QE and ZIRP era. Venture capital, in turn, has become an unserious industry populated primarily by buffoons and charlatans.
By the same token, initial public offerings were once the domain of profitable companies. In the 1980s, around 90 percent of IPOs were profitable. That proportion fell to 70 percent in the 1990s and 14 percent during the 1999-2000 dot-com bubble. Since then, profitability has remained a second thought to IPO issuers and their investors, with the average year seeing only a third of IPO companies at profitability.
Lest we forget real assets, for the last several years commercial real estate has offered prospective investors negative leverage—a condition where the interest rate to finance a commercial building is higher than the initial cap rate (profit divided by purchase price) on the asset. The magnitude is significant, with apartment buildings today typically yielding at least 100-150 basis points (1.0 percent to 1.5 percent) less than the interest rate on the debt used in acquiring them. While not the only factor in commercial real estate returns—especially if investors hold for longer periods—initial negative leverage of that magnitude makes profitability to equity holders extremely challenging.
Bullsh*t Earnings
In order to execute a proper analysis of profit and loss, prevailing terms must be understood. Unfortunately, capital markets are replete with performance metrics of all kinds, many of which are useless. A brief review is necessary, after which I will suggest a more useful metric for measuring true profitability.
EBITDA (earnings before interest, taxes, depreciation, and amortization) is a supposed measure of profitability that has become ubiquitous in capital markets, especially in public company reporting.
The metric came into fashion during the leveraged buyout (“LBO”) boom of the 1980s when it was viewed as a reflection of unlevered operating earnings and thus a useful indication of how well a company could service the highly-indebted capital structures entailed following an LBO transaction. Nonetheless, EBITDA caught on as a widely-used metric for publicly-traded companies. The problem is that interest, taxes, depreciation, and amortization may be significant expenses. Leaving them out paints an unrealistic picture of a company’s profitability.
As the late Charlie Munger—Warren Buffet’s long time business partner—famously stated, if you encounter “…any presentation using the word EBITDA…just substitute the phrase ‘bullshit earnings…’”
Moving on from EBITDA, the public market standard for calculating “profit” is GAAP (generally-accepted accounting principles) Net Income. This metric purports to communicate a company’s bottom line earnings—the profits from a company’s sales after all expenses have been deducted. However, expenses within GAAP are defined somewhat loosely. A hypothetical example will illustrate.
A four-unit rental building earns $1,200 per month in rent while incurring maintenance costs of $400, property taxes and insurance of $500, and depreciation expense of $200. Damage caused by the local weather requires the roof to be replaced each month at a cost of $500. By GAAP standards, this building is profitable to the tune of $100 per month. GAAP counts roof replacement as a capital expenditure—not an expense—thus inflating profits. In reality, the building loses $200 per month.
Commercial real estate owners and brokers have, for years, treated their marketing materials in similar fashion, shoving anything that could be deemed capital expenditure “below the line,” thus inflating their profitability and demanding prices in the sale market on that basis. A better computation is needed to look through GAAP Net Income and arrive at a more precise determinant of business profitability.
Free Cash Flow, Properly Calculated
Free Cash Flow (FCF) or Free Cash Flow to Equity (FCFE) is a non-GAAP metric that may be more appropriate. It’s generally defined as Operating Cash Flow minus capital expenditure. However, even FCF is subject to accounting shenanigans. The use of stock-based compensation (SBC), for example, is an effective method of inflating reported FCF in a stock market bubble.
Rather than paying employees in cash, a company—especially one whose stock trades at a significant premium to fundamental value—can simply use their stock as currency, thus avoiding a reduction in the computation of FCF. And since stock prices are high, the dilutive effect of SBC is often negligible.
Publicly-traded companies now use SBC extensively. As a percentage of sales for companies in the Russell 3000 index, SBC increased over six-fold from 2006 to 2022, with most of that increase coming after the 2008-09 crisis.
In the S&P 500, reported SBC grew by more than 10 percent annually between 2010 and 2022, reaching a total of $192 billion in that final year of analysis. SBC trends have continued in the same direction since then.
The exclusion of principal payments on finance leases when computing FCF also needs to be addressed. A finance lease is an accounting convention that treats lease payments like loan repayments, but they are not loan repayments. They represent a contractual obligation to pay cash to the owner of equipment or a building.
Lastly, working capital considerations may need to be made when calculating FCF. Delaying vendor payments, for example, may inflate FCF in the short term but is unsustainable as a practice. Over time, these effects even out, so this may be a more relevant consideration for shorter term analysis.
Therefore, a useful framework for properly calculating FCF follows:
- Operating Cash Flow (derived from Net Income and shown on cash flow statement);
- minus Stock Based Compensation;
- minus Capital Expenditure;
- minus Principal Repayments on Finance Leases;
- [optional, depending on context] plus or minus Working Capital Adjustments
Using this computation, you will find that two of the “Magnificent Seven” companies—a group worth $15 trillion in combined market capitalization—are perennial money losers.
Vigilance in the Golden Age of Fraud
Financial metrics are used selectively by companies in order to present a rosy picture of performance while obscuring financial reality. Proliferation of such practices is part and parcel of an investor psychology that accompanies speculative excess.
The combination of aggressive accounting and undiscerning investors allows shoddy practices to persist until the source of speculative excess—loose, inflationary monetary policy in the case of the US—subsides. In the meantime, discerning investors should familiarize themselves with the bag of tricks used by unscrupulous CEOs and CFOs, amplified by their cheerleaders in the financial media. In so doing, participants in the capital markets and business world can stay grounded in the moral and productive essentials of the profit-and-loss system while recognizing its distortions in the interventionist economy.
