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Most people do not recognize that it wasn’t until the beginning of the Depression Era, the early 1930s, when the New York Stock Exchange mandated basically what we call today the matching principle: the accounting matching of revenues and expenses, as undertaken in the typical income statement, that a separate form of income determination apart from the balance sheet grew to general use. And so it was not until the Depression Era that the income statement, the matching principle, and the separate determination of net income gained ascendancy as the predominant form of financial analysis. Further, we can see why this would be the case at that time. During the Great Depression income was so scarce and hard to come by that its separate determination was called for. In the early 1930s, interest rates were extremely low, in some cases negative. Banks closed their doors in record numbers, and the power of bankers to influence the course of events was on the decline. Income analysis became more and more important, and net income analysis and the income statement predominated as a form of financial analysis. This persisted until relatively recently.

In the 1970s, with great inflation, income computations according to the traditional methods, with the use of historical costs, became a bit silly and meaningless due to the misapplication of valuation with respect to the balance sheet. The significant level of inflation made these historical costs less meaningful, and what was found on the balance sheet (basically historical cost determined assets that represented unexpired costs) went into the income statement as these costs expired. In that these costs were no longer a reflection of current valuation in a highly inflationary era, the balance sheet (which was already in considerable disrepute) went into even further decline as an analytical tool, and an understanding developed that the income statement was not very meaningful, either, without some adjustments. Accordingly, price level adjustments that had been developed for some time resurfaced as a means of enhancing the analytical use of both the balance sheet and the income statement.

Basically, the conditions of the time led to an understanding that neither the income statement nor the balance sheet was of much analytical value in dealing with the prevalent business environment. Different product costing techniques, such as LIFO, FIFO, and average, led to very different accounting results. Similarly, different depreciation techniques – straight- line, double declining balance, etc. – led to very different income statement and balance sheet results. And while new financial analytical methods were called for, it was really old techniques that were found to deal with the requirements of the times.

Cash flow analysis became more and more in vogue because of its ability to deal with the economic exigencies of the time and its lessened degree (as compared to the balance sheet and the income statement) of being subject to accounting manipulation by the preparers of financial statements in order to portray the desired results. Today, cash flow analysis truly is by far the most important kind of financial analysis, and most finance professors now deal with their students in terms of free cash flow (cash flow from continuing operations less capital expenditures and dividends) in that it leads to an enhanced ability to effectively analyze the firm, regardless of the level of inflation or the accounting techniques that are used. That is, free cash flow provides a far better handle on the solvency and productive operations of a firm than the income statement or the balance sheet. This is especially true in difficult and volatile economic times.

With the return of the ascendancy of cash flow analysis after many centuries have also come many alternative ways of understanding cash flow. Free cash flow is just one of them; there are others. It has been an interesting metamorphosis through the years. We’re back where we started at the dawn of the Industrial Revolution, with cash flow predominating as a financial analytical tool.

The high-profile bankruptcies of the 1990s and early 2000s have certainly helped bring about this change. Moreover, the financial bubble at that time, which in many ways reflects other such bubbles of other centuries, also reflects this – a need to get away from allowing businesses to tell us what they want to tell us and what they want us to believe they are worth. We have to look beyond some of the inherent misstatements in the balance sheet and the income statement and the amenability of these forms of financial analysis to manipulation by some unscrupulous financial managers who sometimes find it desirable to tell lies to cover misdeeds or poor financial performance. It is important that financial analysts employ techniques that will effectively determine the value of businesses they are studying.

There are many types of financial analysis. You can almost call anything having to do with dollars financial analysis; as long as you’re dealing with a dollar sign, you’re engaging in some form of financial analysis.

A bit of history with respect to the relative emphasis of various forms of financial analysis or accounting statement types through the years might be useful at this at this point. There has been a very interesting change through the centuries in the focus of financial analysis and the relative importance of the various financial statements. Cash flow analysis was the predominant focus of financial analysis at the dawn of the Industrial Revolution. Businesses at that time, when they opened their doors, had to be sure they could last the day, and so they had to have cash to make change and sufficient liquidity to secure their other transactions. Basically, what was needed was sufficient cash to satisfy what economists like to call transaction demand and some security beyond this for purposes of what economics refer to as a precautionary demand for cash. So cash flow analysis is what was focused on at that time.

Businesses were simple; there was no complex manufacturing, where the determination of product costs and the requisite financial statements are very significant. Enterprises were predominantly simple, service-type businesses: trading and very rudimentary manufacturing, and such.

Then, in the early 1800s, what was then Britain (United Kingdom now) passed what were known as the Company Acts. The British Company Acts mandated the compilation of something pretty close to what we now know as the balance sheet, and that changed the focus from a cash flow analysis to a balance sheet analysis. This change was prompted by banks, which understood borrowing customer solvency in terms of a relationship between assets and liabilities; hence an emphasis upon the balance sheet.

Bankers are now far more intelligent and sophisticated in financial affairs, understanding that it is really income and basically cash flow that will repay their loans. But bankers at that time wanted to look at balance sheets. They believed that in the event of the insolvency of their borrowers, they could proceed against the physical assets of these borrowers and wished to know the book values of these assets, as well as the amount of claims standing in line with them for satisfaction. This knowledge required balance sheets prepared on the basis of historical costs. So income, while of some importance as a measure of business stability and success at the time, was of secondary consequence and was computed indirectly.

You would determine net income in those days according to what is now referred to as the net worth method. The net worth method of net income determination is basically as follows: you compute net worth at the beginning and at the end of the year (Assets – Liabilities = Net Worth), as found on the balance sheet, compare these two net worth figures, add back a capital consumption allowance (depreciation), and you have your net income for the year. Accordingly, net income was not computed directly at the time as is done today, but was ascertained as a derivative from the balance sheet. This was because, as noted, at the time net income was of secondary importance, and cash flow was of even less consequence.

As time went on and there were financial upheavals and monetary panics aplenty on both sides of the Atlantic, investors and bankers began to realize the limited nature of the net worth method, not only for an accurate determination of net income, but also as a gauge in determining expected business solvency. Change in the focus of financial analysis and the relative importance of the various financial statements and income determination methods was on its way. However, it is interesting to note how long it took before a fundamental alteration took hold in the emphasis placed upon the various types of financial analysis.

With accounting earnings, we might use a somewhat complex term to explain what is meant. The concept at issue is epistemology. Epistemology is an understanding of the theory of knowledge and how and in what ways and degrees things are known. In some situations you have a very high degree of accuracy attached to a given dollar figure – for example, printed stock prices on the financial page. The degree of reliability of reported stock prices should be understood in relation to the reliability and accuracy of reported accounting earnings. With respect to reported accounting earnings, some companies apply very conservative, withdrawn, and limited accounting principles to recognize revenue in a very limited way and recognize expenses more rapidly. Other firms do precisely the opposite, recognizing revenue in an expansive fashion, while slowly writing off expenses. In the boom years of the 1990s, many firms (technology firms in particular) engaged in the latter practice of reporting current earnings at as high a level as possible through rapid revenue recognition and delayed expense write-offs. Thus, the reported net income figures of firms using greatly differing accounting principles are inherently dissimilar in a qualitative fashion and simply cannot be compared without adjustment.

Accordingly, we must apply a far lower level of reliability to reported accounting earnings (and the comparability of this figure across different firms using different accounting conventions) than we do to reported stock prices. In essence, there is a significant epistemological difference between these two concepts. And again, there are no rules: Two financial statements can have the same dollar per share of earnings and mean something very, very different in one case versus the other. So it’s hard to speak in terms of rules governing financial affairs.

If we had to list ten immutable rules with respect to finance, all ten of them would be, “Be skeptical.” Just as they say about real estate, “Location, location, location,” we should say, “Be skeptical of what you’re told” ten times. Look beneath the simplistic nature of things. There truly are no immutable rules other than obvious mathematical relationships. If you invest a dollar today, and you get two dollars back at the end of ten years, every financial analyst knows that your rate of return is 7.2 percent compounded annually. This financial relationship between inflows and outflows of funds will not change over time. To compute the present value of a financial commitment, once the inflows and outflows of funds on the commitment are known, every financial analyst will get the same answer. This is an unchangeable rule. You put the numbers in the computer and press a button, and everyone will agree as to the outcome. But it’s only those kinds of things that are hard and fast rules; everything else is highly changeable. The really important, significant, and interesting issues relate to the inputs (usually the inflows and outflows of funds). Once we can agree on these inputs, we will all get the same answers. But agreement on these inputs is not easy and depends on the many assumptions that are made in any such determination of project cash inflow and outflows.

Nevertheless, there are a few formulas, theories, and hypotheses that have risen to a high level of ascendancy in terms of understanding financial markets. Again, none of these models is believed in the sense of immutability.

CAPM, as noted, is simply a way of relating risks and returns. CAPM was originally developed as a means of valuing financial assets. However, it has been used less successfully in capital budgeting, which refers to the valuation of real assets.

There is also the Black-Scholes model, which is an options pricing model that has additionally been extended in terms of contingent liabilities and other areas. Black-Scholes has been found to be a very useful model with respect to many valuation problems.

But there have been a number of departures from both of these – the so-called arbitrage pricing theory is one. All of these models are fairly old and well used. There was a time, 20 or 25 years ago, when in the classroom we would use these terms and teach our students these things, and find that in executive development programs in the investment community, they weren’t widely used. Now they are. Beta and other measures of risk are as common in the contemporary investment community as blood pressure, PSA, and other measures of physical health are in the doctor’s office.

In essence, what were once purely academic models have now risen to the status of general acceptance in the professional business and investment communities, a development of the last 20 or 25 years. Before that time, these academic terms and concepts weren’t quite as popular as they now are in the professional world. One of the primary reasons for the adoption of these academic concepts by the professional business community is the trend for students to be trained in the academic world before entering business. The MBA is now virtually a necessary credential for entry at the highest levels into the business community. Executive training programs have become commonplace. And some of the highest-level academics are now going to work in the business world, either as consultants or as employees in some of the biggest Wall Street firms. Many academics have done that – and in so doing have fattened their pocketbooks considerably. But the overall result is a greater closeness over the past quarter century between the academic and professional business worlds.

A concept not yet developed in this chapter that has considerable current interest both in academic and professional business circles is the efficient markets hypothesis (EMH). EMH is the notion that information drives stock prices, comes to the market randomly, and is instantaneously impounded in these stock prices. A clear implication of EMH is the disutility of attempting to predict stock price movements. Many studies have tested the validity of EMH, and while some exceptions have been found to this concept, most of these exceptions are to be expected on the basis of institutional characteristics of markets and other such factors. In essence, while some inefficiencies have been found in major markets, such as the United States, this condition is somewhat unusual and rarely represents viable investment opportunities for the individual investor. In general, market inefficiencies are far greater in emerging markets than in developed markets. Yet, anyone who has lived through the last ten years understands that inefficiencies can plague developed capital markets, as well.

A word of caution: All models make assumptions. For example, CAPM assumes no transaction costs, no taxes, and, among other things, the stability of beta over time. You have to understand the assumptions behind these models, and all of them abstract and go into somewhat unrealistic assumptions to make reasonable projections of risk-return relationships. It’s not enough just to say, “I know the equation of CAPM.” That’s easy enough. You actually have to understand what’s behind the equations – basically the assumptions on which these equations have been built.