Investment Decisions: The Nexus Between Accounting and Valuation

This post is authored by MOI Global instructor Javier Lopez Bernardo, portfolio manager and senior investment analyst at BrightGate Capital, based in Madrid, Spain.

Javier is an instructor at Best Ideas 2022.

This following article has been excerpted from a letter to BrightGate investors.

I think it is the right time to write some words on how I think about the nexus between accounting and valuation, and how such a framework informs my investment decisions. The summary metrics that I provide [in my letters] usually go unreported in other funds, and here I will argue why these metrics have more informative content than the traditional ones, and how they are indissolubly tied both to a firms’ core business and their accounting. In other words, these metrics are the ones I would like to receive if I were in your place trying to obtain a clear overview of the Fund’s portfolio.

Although it is usually argued that valuation is not a differential part of the investment process, for “everything has already been invented”, I cannot but disagree with such a statement. Although in the end the success of an investment boils down to the knowledge of the business and its own future dynamics, a correct study of the valuation and the accounting allows a better understanding of the business and to avoid serious mistakes later.

The exposition that follows is necessarily a simplification of our financial models, but it will be enough to grasp the conceptual framework. The method that I employ to value business is the residual income model (or economic profits, as they are known in the academic literature), which says that the value of every asset is given by its current book value in the balance sheet plus those future discounted earnings obtained above the cost of capital – residual or economic earnings. If we have an asset with a book value of 100€, and we expect it will yield returns of 7% (7€ of profits at perpetuity), and our cost of capital is 7%, the asset should be valued at book value – no more, no less.

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