Accounting Profit

Accounting profit (also known as book profit or, in its final form, net income) is the number that gets all the headlines. It's the famous “bottom line” you'll find on a company's income statement. In simple terms, it's what's left after you subtract all the explicit, out-of-pocket business costs from the total revenue a company has generated over a specific period (like a quarter or a year). This calculation is strictly governed by accounting rules like Generally Accepted Accounting Principles (GAAP) in the United States or International Financial Reporting Standards (IFRS) elsewhere. Think of it as the official scorecard of a company's profitability, meticulously prepared by accountants. It answers the question: “Based on the official rules, did we make more money than we spent?” While it's an essential starting point for any financial analysis, for a savvy investor, it's rarely the final word on a company's true performance.

The concept of profit can be split into two camps, and understanding the difference is crucial for any investor. Accountants and economists look at the world through different lenses.

• Accountants are historians. They are concerned with what actually happened. They meticulously record and subtract all the tangible, demonstrable costs—the ones with receipts. These are called explicit costs: wages paid to employees, rent for the office, the cost of raw materials, and utility bills. The formula is straightforward:
  1. Accounting Profit = Total Revenue - Explicit Costs
• Economists (and Value Investors) are forward-looking and concerned with choice. They agree that explicit costs are important, but they add a crucial second category: implicit costs, more famously known as opportunity costs. This is the value of the next-best alternative you gave up to pursue your current path. It’s the income you could have earned but didn't. The formula for economic profit is therefore more comprehensive:
  1. Economic Profit = Total Revenue - (Explicit Costs + Implicit Costs)

For example, if you quit a $100,000/year job to start a business that reports an accounting profit of $80,000, an accountant would say you're profitable. An economist would say you've made an economic loss of $20,000 because you gave up the better alternative.

Value investors are trained skeptics. They know that the “bottom line” number can often hide more than it reveals. They dig deeper because accounting profit has some serious limitations.

Because accounting profit is based on a set of rules, those rules can sometimes be bent. Management teams, under pressure to meet quarterly earnings expectations, can make choices that boost short-term accounting profit at the expense of long-term health. They might:

• Change how they account for inventory.
• Aggressively recognize revenue before the cash is in the bank.
• Capitalize expenses that should have been expensed, pushing costs into the future.

This is why reported profit can sometimes be an opinion, not a fact. The real story is often buried in the notes to the financial statements.

This is the big one for value investors. A business isn't truly successful just because it's making an accounting profit. It must earn a return on the capital invested in it that is higher than the opportunity cost of that capital. If a company invests $100 million to generate an annual accounting profit of $1 million (a 1% return), it's hardly a success when that same money could have been put in a simple index fund to earn 8%. Even though it's “profitable,” the business is destroying value by pursuing a low-return project. A great business must generate returns that exceed its cost of capital.

Legendary investor Warren Buffett has famously said he prefers to look at “owner earnings,” a concept very similar to free cash flow (FCF). Why? Because cash doesn't lie. Accounting profit includes many non-cash expenses, with the biggest culprits being depreciation and amortization. These are accounting methods for spreading the cost of an asset over its useful life. While they reduce accounting profit, no actual cash leaves the company's bank account in the current period. Free cash flow adjusts for these items and gives a much clearer picture of the actual cash the business is generating that is available to be returned to shareholders or reinvested.

Accounting profit is the official story, the one presented in the annual report with a glossy finish. It’s an indispensable tool and the starting point for almost all analysis. However, it is not the whole story. A true value investor acts like a detective, using accounting profit as the first clue but then looking for the economic reality underneath. By focusing on the powerful concepts of economic profit and free cash flow, you can better distinguish a truly wonderful business from one that just looks good on paper.