Enron: Accounting Scandal or Bad Business

I know—Enron is old news. If you don't remember the scandal, Enron was an energy and commodities trading company that went from massive to bankrupt in just 16 months. Once the largest marketer of natural gas in North America and the United Kingdom and the largest marketer of electricity in the United States, Enron was wrought with scandal and deception which resulted in a total loss to many investors.

Could investors have avoided the loss altogether? Can we protect ourselves from accounting scandals?

By the end of 2000, Enron was on top of the world. Its stock had hit all-time highs and revenues topped $100 billion. Everything seemed hunky dory so long as Enron and their accountants at Arthur Anderson kept cooking the books.

Price Follows Value

Throughout 2001, the stock began falling from its $90+ highs, all the way down to $1 a share. On December 2, 2001, Enron declared bankruptcy. Soon after, the SEC uncovered accounting scandals and flat out lies from both Enron and accounting firm Arthur Anderson. Investors lost billions...but it could have been avoided.

If you had looked at Enron's owner earnings from 1994 to 2000, you would have never been burned. In fact, you would have never invested in the first place. (Unless you were an Enron employee who had no choice but to own Enron stock in your 401k)

Forget Accounting, Follow Cash

Even using Enron's cooked income, you could have spotted the Enron problems long before they happened. After all, it is fairly easy to manipulate net income for Wall Street and the IRS. But, cash is cash, and it is hard to say that your bank account has an extra $1 million when the statements clearly show that it doesn't.

Take a look at Enron's owner earnings from 1994 to 2000:

Not only did Enron burn through $1.9 billion of cash, they had just three positive years out of seven. Even if you thought that 2000 was the turnaround and that Enron was on track to rapid growth, you still couldn't buy.

A Random Guess at Value

In 2000, Enron produced $1.22 billion of owner earnings—the first positive year in four. Using pure speculation (I hate to do it, but I will), let's assume that Enron would have grown 15% a year for the next ten years, and then slowed to 5%. Sure, there's no basis for our reasoning, but let's forge ahead.

Using the above assumptions, Enron would have been worth $60 a share using a 9% discount rate. With a 50% margin of safety, we couldn't buy Enron for more than $30 a share, and certainly not at $90.

By the time Enron dropped below $30, the reports of scandal were coming in. If you can't trust the financial statements, you can't own the business—and you would have gotten out as fast as you had jumped in.

Where Was Wall Street?

Allow me to steal a quote from this Forbes article:

Major Wall Street analysts listened intently to the story and few questioned it. As of [October, 2001], 13 analysts covered the company. Eleven recommended it as a "buy" or "strong buy." Just one said "sell" and the other said "hold." This was just one week before the roof fell in, and Enron announced it would sell itself to Dynegy, its crosstown rival.

And those are the firms and people overseeing the financial futures of millions of Americans.

Accounting Scandal?

If you played Wall Street's game, you would have been surprised, and outraged, by Enron's accounting scandal that wiped the company off the face of the earth. If you invested like a business owner and used data and reasoning to calculate an intrinsic value, you never would have bought it in the first place.

Can we protect ourselves from accounting scandals? Not entirely. But I'm a gambling man (in Vegas at least) and I'd be willing to bet that we could avoid 99% of all scandals long before they shock Wall Street and crush the mutual funds. Why? They trade stocks; we own businesses.

And that will forever give us the edge in the long-term.

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