The One Accounting Skill All Stock Market Investors Need

Wall Street Two Signs

Investing and accounting go hand and in hand. Yet while many investors spend time looking at balance sheets and income statements, there’s one accounting skill that isn’t often talked about. And in my experience, it’s incredibly important to security analysis investing success!

So what is this mysterious accounting ability? Well, to put it simply, it’s about translating business accounting ratios and popular financial metrics into an easy-to-understand narrative that describes what’s happening. And although this can take some practice, it’s probably easier than you think.

That’s why I want to spend the rest of this article sharing a simple example you can keep in mind. My hope is that these easy ideas can help you interpret accounting concepts and understand how they relate to the operating trends of the underlying business. From there, deciding whether or not to invest becomes much more straightforward. But let me show you what I mean.

Accounting For The Story Of A Business:

In my experience, accounting classes can be a little dry. As a result, it’s sometimes hard to remember that all we’re really doing is keeping track of how money flows through a business. And that business is run by humans, who are trying to achieve an objective.

Now I know this might sound too simple, but it’s through this lens that we can use accounting to better determine how well this business is achieving what it set out to do. And once you know that, deciding whether or not to invest (and at what price) becomes much more clear.

But to help you see this concept in practice, let’s walk through an example:

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Accounting Tips For Uncovering The Story Of A Business: 

The easiest way to illustrate the story told by accounting is to start with a business you already know. This will highlight the concept. And once you understand the theory, it can become easier to apply to other companies.

So as an example, let’s start with Apple. You probably know that they produce iPhones, computers, and other electronic devices. They also have software and subscription services consumers can interact with to fully round-out their experience. And this whole ecosystem is continuing to grow.

Intriguingly, Apple is also a premium provider in their marketplace. They charge a high price, and provide a quality product. But what does this business description have to do with accounting?

To get the answer, let’s take a look at some numbers. And by the way, Morningstar provides great historical data so you can see the long term trends in these accounting metrics. Here’s where you can see the data for Apple stock:

  • Revenue: Over the last ten years we can see the sales numbers have trended higher. This tells us that demand for Apple products is growing and that the company has done a good job meeting this demand.

 

  • Margins: We mentioned earlier that Apple is a premium provider, and gross margins reflect this reality. Steady profit margins show that the company can charge high prices and still collect cash from sales. On the other hand, if margins were closer to zero, I would question the assumption that Apple is a premium player.

 

  • Balance Sheet and Cost of Debt: Apple has a reasonable debt load, a huge cash pile, and a small amount of interest expense. This reflects the strong competitive position of the business. If, on the other hand, Apple was scrambling to compete in their markets, you’d expect to see a balance sheet more bloated with debt.

 

  • Consistency: In all of these accounting metrics, Apple has been consistent. It’s not a cyclical business that goes boom and then bust- and chances are your experience reflects this business model. In today’s digital age, people are always on their iPhones and will replace them in a hurry if a device is lost, stolen or broken.

Now I know this is a pretty simple illustration. But I hope the underlying idea makes sense to you! Instead of just looking at sales numbers or margins as numerical facts on a page, these metrics can tell us about the fundamental trends that drive the underlying business.

Even better, by looking at these numbers over time, you can get a real feel for the consistency of the company. And the best thing is, it works for any business! From cyclical energy and industrial firms, to fast-growing online enterprises, the numbers tell the real story.

And unfortunately, far too many investors fail to interpret the accounting for what it really is: an objective narrative of the business activities that underpin the stock price!

Conclusion: Let the Numbers Be Your Guide

 One of the reasons I love accounting is that it’s a great way to fact-check qualitative claims. The next time you hear of a great investment opportunity, take a look at the financial statements. See if you can find the alleged competitive advantage reflected in the accounting. Because only then is it worth considering a potential investment!

Thanks to this guest post from Jay Delaworth at Intelligent Trend Follower. You can email Jay at

jay@intelligenttrendfollower.com

Good luck!

Image:

Wall Street Two Signs, Terrapin Flyer, Wall Street (CC BY-SA 2.0)

Ken Boyd

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies

Co-Founder: accountinged.com

(email) ken@stltest.net

(website and blog) http://www.accountingaccidentally.com/

(you tube channel) kenboydstl

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