The New Value Factor | The Acquirer's Multiple®

During his recent interview on The Acquirers Podcast with Tobias, David Trainer, CEO of New Constructs discussed The New Value Factor. Here’s an excerpt from the interview:

Tobias: There’s a nice paper that’s just come out about New Constructs and its core earnings methodology. The line that really stood out to me was that the core earnings provides a more accurate and persistent measure of a firm’s profitability than traditional metrics. There’s two ideas in that that I want to understand. The first one is, let’s understand, what are core earnings?

David: Core earnings are effectively just a better way to measure profits. Some professors, I think, maybe the last time we talked, I mentioned it and started to study this. A couple of guys out of Harvard Business School and MIT Sloan learned about New Constructs and were interested in this work we were doing and really the big question that came out of it was, “All right, all this extra work that New Constructs does in the footnotes, does it matter? Does it give you incrementally better data, enough better to generate idiosyncratic alpha or alpha that can’t be explained in other factors like traditional profitability, or value factors, or momentum, or sector weightings, or tilts or size?” The paper came away with, yes, absolutely we can, and there is nothing else like it in the marketplace. Of course, in order for that paper to get published in a peer-reviewed journal, they had to prove these things to be true, which they did. The paper was published in the Journal of Financial Economics.

The next step for us was to take that insight and say, “Okay, how do we deliver alpha? How do we make it easy for our clients, whether your fundamental manager or client manager, to make money on that insight?” So, it effectively says, core earnings is a better measure of profits. So, we can then look at the difference between core earnings and whether it’s accounting earnings, or street earnings, or consensus earnings. The difference between core earnings and the other traditional measures of earnings is what we call earnings distortion. That’s what we’re calling the new value factor. Because that distortion number is shown to, on a standalone basis, produce idiosyncratic alpha. The paper that you mentioned, Toby, from ExtractAlpha of 10.3 compound on annual return over the last five years and a long-short portfolio, and I think something like 9.2% of that is pure idiosyncratic alpha. Yeah, it’s the earnings distortion number, and earnings distortion is the difference between core earnings and traditional measures of earnings.

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