Using Graph Theory, Ph.D. Student Jane JaeYeon Pyo Demystifies Financial Statements

Tepper School student Jane Pyo’s research moves beyond traditional financial analysis.

Jane JaeYeon Pyo, a third-year Tepper School of Business doctoral student, has developed a way to measure the distances between financial statements and a novel method of interpreting them, offering a new lens through which to view structured financial statements. Before pursuing a Ph.D., Pyo worked in public accounting, focusing on mergers and acquisitions advisory. Her experiences involved reading and analyzing extensive amounts of financial statements for financial due diligence engagements, which helped her understand the embedded deep informational richness within financial statements. She was astounded that despite relying on only four standardized, seemingly fragmented financial statements, specialists consistently glean cohesive insights about a firm’s performance. At the Tepper School, Pyo combined her work experiences with graph theory, leading to her current research on formally modeling and analyzing these complex informational interdependencies, leveraging the financial statement structure. 

The traditional view of a company's success often boils down to a few key figures like revenue or earnings. Yet, Pyo argues, this overlooks the complex narratives of activities that generate those numbers. A management’s decision-making on everything from operational restructuring and financing to long-term investments, and these decisions, while impacting the bottom line, are often unobservable, but indirectly manifested in the face of the financial statements. As Pyo puts it, "When two firms achieve the same earnings, one may have done so by maintaining existing activities, while the other through a complex set of changes restructuring operations, securing new financing, or capitalizing on past technology investments." 

To capture these intricate changes, Pyo turns to a branch of mathematics often used to map networks of relationships and provides a framework for modeling the connections between a company's accounts. Each account becomes a node, and the transactions between them become the edges, with the direction and weight of the edges representing the amount and the flow of money. Information theory then provides the tools to measure the degree of change in these networks, using measures like Kullback-Leibler divergence (a type of statistical distance) and Euclidean distance (the length of a line between two points). 

A company’s financial statements are like a series of snapshots, each capturing a moment in its ever-changing metabolism. Pyo's measures allow us to compare these snapshots, quantifying how much the company changed from one moment to the next. A high degree of change might indicate a company in flux, perhaps undergoing restructuring or pursuing new investments. A low degree of change, on the other hand, might suggest a more stable, or even stagnant, entity. 

Pyo's research reveals some intriguing patterns. Companies that maintain a consistent financial structure tend to show stable or declining performance over time. This might seem intuitive – a company that keeps doing the same thing might be expected to achieve the same results. However, the more interesting finding lies in companies that undergo significant structural changes. These companies often experience initial declines in profitability but achieve significantly higher long-term revenue growth. This insight challenges the focus on immediate results, suggesting that sometimes, to move forward, a company must first endure a phase of growing pains to build stronger foundations. 

However, the market doesn't always appreciate this nuanced picture. Pyo's work indicates that investors tend to react negatively to companies undergoing significant structural changes, even when those companies announce positive earnings news. The market may view such changes as introducing too much uncertainty, clouding the good news. This discounting effect persists, often deepening in the months following earnings announcements, despite the evidence of long-term performance improvements. 

Pyo's research opens new avenues for understanding the complex relationship between corporate structural changes and market reactions. It complements existing methods of measuring firms’ activities by providing a more direct measure of the structural changes a company implements within the company. 

The implications of this research are significant. For investors, it suggests looking beyond the immediate headlines and considering the underlying dynamics of a company's financial statements. For managers, it highlights the potential trade-off between short-term pain and long-term gain, and the challenges of communicating complex organizational changes to a market that often craves simplicity.

Overall, Pyo's work may lead to a more sophisticated understanding of how companies evolve and adapt. By decoding the secret language of the ledger, she offers a new perspective on the forces that shape the corporate world. She plans to continue developing methods that formally characterize financial statement structure and informational content. Her experience on the practitioner side has led her to ask, “How can we extract more structure, signal, and meaning from the financial reports firms produce?” There is still untapped potential in extracting information from financial statements, and Pyo intends to realize that potential through her future research.