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Bill Nygren Explains How to Look Beyond GAAP Accounting

·2 min read

- By Stepan Lavrouk

Accounting is the language of investing and finance. As with any language, it is very helpful to have a set of standardized rules and conventions that allow different parties to understand one another. This is what generally accepted accounting principles, or GAAP, are - a standard that allows investors to compare different types of companies to one another. With that being said, even the best accounting is only a picture of reality, and any picture can only capture part of the truth.

Oakmark Funds portfolio manager Bill Nygren (Trades, Portfolio) recently gave an interview to the "Graham and Doddsville" newsletter explaining how investors can look beyond the accounting conventions that we use to uncover hidden value in businesses.

The balance sheet doesn't always tell the full story

The first thing we need to establish is this is not an invitation to ignore well-established accounting norms. Any good analysis must start from a skeptical perspective that seeks to weed out any red flags that might present themselves. With that being said, these are the non-accounting factors that Nygren thinks investors can look at:

"With a company like Amgen (NASDAQ:AMGN), very heavy R&D spending was depressing earnings and making it look very expensive relative to the pharma industry. But if you looked at enterprise value to EBITDA plus R&D, Amgen looked much cheaper than the pharmas and it also had much longer patent protection and much better growth ahead of it. That ability to make exceptions to GAAP metrics when we don't think that GAAP reflects the real world carries through to today to positions that are important to us, like Alphabet (NASDAQ:GOOG), where its spending on 'Other Bets' goes through the income statement, depresses earnings by something like $6 a share and is not reflected on the balance sheet."

Nygren points out that if Alphabet (i.e., Google) had invested the money that it spends on "Other Bets" with a fund or venture capital firm, that investment would be listed as an asset on its balance sheet, as opposed to an expense depressing earnings. In fact, Alphabet is probably a better capital allocator when it comes to funding new technologies than most venture capital firms because it has the best software engineers working for it already, as well as access to some of the strongest computing power in the world. Financial statements are great, but sometimes they don't tell the full story.

Disclosure: The author owns no stocks mentioned.

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This article first appeared on GuruFocus.