The Problem with Picking Stocks? Your Data Stinks.

David Ning recently wrote an excellent post explaining Earnings Per Share (EPS), which is one of the most important pieces of data when analyzing a company to determine whether or not you want to invest in it.

David mentioned one thing though that really reminded me as to why I never try to pick stocks: Different people calculate EPS in different ways. For example, some base the calculation on earnings in the previous period, while some use projected earnings over the next period.

David wisely suggests that you do your own calculation of EPS by using data from the company’s financial statements. This way, you can be sure that when you’re comparing two companies’ data, the calculations were at least made using the same formulas.

Unfortunately…

EPS is just the tip of the proverbial iceberg.

From what I’ve seen working in the field of accounting, most accountants tend to be reluctant to try to pick stocks. My (completely untested) hypothesis is that it’s a result of our awareness of the imprecise nature of the information that goes into a company’s financial statements. (A company’s financial statements are a primary source of information for investors when considering whether or not to purchase a stock.)

For example, even if you know that the EPS calculation was done using the same formula for each company, it still might be completely meaningless. Why? Because calculating a company’s EPS requires knowing the company’s net income. And the calculation of net income includes (literally) thousands of different assumptions and estimates, which can be different from company to company.

Take depreciation for example.  (Depreciation is the process by which the cost of an asset is spread out over its useful life.) Any time a piece of equipment (or furniture, or a building) is purchased, three questions have to be answered in order to determine how much depreciation expense to recognize each year:

• How long do we expect to use the asset?
• Do we think that the asset will be worth anything by the end of that time period?
• What method of depreciation do we want to use? (There are several. Some of them result in more expense in the earlier years. Some of them spread the cost out more evenly from year to year, etc.)

So, if two companies purchased the exact same asset, but answer the above questions differently, they will report differing amounts of depreciation expense–and thus, differing amounts of net income–each year.

Now to get a sense of how this plays out in real life, multiply that uncertainty by a few thousand assets.

And that’s just depreciation expense. The same types of assumptions and estimates are made when calculating amortization expense, cost of goods sold, revenue from construction (or other long-term) contracts, expenses resulting from fires/flooding/hurricanes/lawsuits, and so on.

In fact, in accounting, we often say that numbers can only be trusted to their first significant digit. In other words, an expense of $2.4 billion could very easily be reported as $2 billion by another company if different assumptions had been made.

Let’s look at an investing-related example.

Imagine you’re making a comparison between two companies’ “current ratios.” (Current ratio is the ratio of a company’s current assets to current liabilities. It’s often used to determine a company’s ability to meet its short-term financial obligations.)

Imagine that Company A has a current ratio of 1.45, and Company B has a current ratio of 1.02. It might be tempting to say that Company A is a better investment, because it has a current ratio that’s almost 50% higher than that of Company B. In reality though, that level of difference could easily be attributed to the use of different accounting methods, assumptions, and estimates.

To say that Company A’s current ratio is significantly higher than Company B’s is to delude yourself. The data simply isn’t good enough to make that statement with any meaningful certainty.

And before you get any ideas about trying to come up with ways to adjust for the different assumptions and estimates, allow me to save you the time. It’s impossible. You don’t have the necessary information to do so. (You’d need information as to the purchase price for all of a company’s assets, how long they expect them to last, and so on. And no matter how nicely you ask, they’re unlikely to give you this data.)

If you want to try and pick stocks, be my guest. Just be aware that the data you’re using isn’t nearly as precise as it appears.