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As Wall Street hits new highs, investors should take a close look at the underpinnings of the stock market boom.

Consider, for instance, a downbeat but intriguing take from Jesse Livermore, a pseudonymous blogger with a wide following in the U.S. financial community. In a research paper for O’Shaughnessy Asset Management, he argues corporate profits in the United States have been systematically overstated for decades. According to his forecasts, annual returns over the next decade for U.S. stocks will be underwhelming, although not as devastating as some bears predict.

Mr. Livermore’s paper focuses on how U.S. companies conduct their accounting. Generally accepted accounting principles (GAAP) in the United States insist businesses record the value of assets on their balance sheets at the price at which those assets were acquired.

Corporations do not adjust asset values upward to account for inflation. Over time, this practice means there is a growing gap between the reported value of assets on the balance sheet and their actual inflation-adjusted value. This gap is especially wide during times of high inflation.

Mr. Livermore argues the gap has a couple of insidious effects. One is that earnings are overstated because depreciation – the amount of the original purchase price that gets written off every year – doesn’t cover the actual loss of economic value a company is experiencing. Another is that book value – that is, the value of the company’s equity – gets understated, because it is based on historical pricing, not what it would cost to replace those assets at today’s prices.

An extremely simplified example can help demonstrate his points. Imagine you bought a machine for $100,000 a few years ago. You record it on your balance sheet at the acquisition cost and plan to depreciate it over the expected 20 years of its useful life at $5,000 a year.

This is perfectly fine by U.S. accounting standards. But a few years after your purchase, the replacement cost of an equivalent machine might be more like $150,000. If so, the amount of depreciation you are deducting is considerably below what it would cost to replace the economic impact of the old machine at the end of its useful life. The understated depreciation makes your business appear more profitable than it really is. At the same time, the book value of your equity appears lower than it really is, because the historical value of the machine doesn’t match its higher current value.

The combination of the two distortions can result in misleading figures. Calculations of return on equity (ROE), a gauge of how profits stack up against a company’s book value, can be especially out of whack, according to Mr. Livermore.

Conventional measures say large stocks in the United States have averaged more than 12 per cent ROE over the past half century. This doesn’t jibe with the stock market returns those stocks have generated for investors. Typically, those returns are slightly more than half the claimed ROE.

Why this big gap? Mr. Livermore argues it is because earnings are overstated and book values are understated. When you adjust figures properly to account for the gradual effect of inflation over the years, he calculates true returns of large U.S. companies on inflation-adjusted equity, or what he calls “integrated equity,” have been only about 4 per cent a year on average since the 1960s. True earnings, after the proper adjustments, have historically been about 20 per cent lower than the stated values.

Rather than focus simply on reported earnings, investors should also look at the amount of free cash flow a company is generating, he says. Free cash flow, a gauge of how much cash a company is throwing off after capital expenditures, avoids many of the distortions that go along with GAAP.

The good news is at least some of the distorting effects of inflation have eased in recent years. “Contrary to what some might initially expect, the hypothesis [that free cash flow matters] is bullish for the current market’s valuation” because free cash flow as a share of earnings is much higher today than in the past, suggesting today’s earnings are less overstated, Mr. Livermore argues.

His estimates suggest the U.S. market appears primed to produce average annual returns of somewhere between 3 per cent and 6 per cent over the decade ahead. That is lower than historical averages; it also doesn’t preclude a nasty bear market at some point. But, in comparison to today’s dismal bond yields, it suggests stocks still have something to offer.

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