The byline for chapter 6 reads: Beware of Paying for Profitability. That might seem strange as surely firms add value by becoming more profitable. And value investors often advise to invest in highly profitable firms. Here are the reasons for the warning (as chapter 6 further explains):
- The denominator of RNOA excludes investments that are not booked as assets on the balance sheet. If the income from these omitted assets are in the numerator, RNOA is high even though the firm might not be particularly profitable. The Coca Cola Company is an example: It’s RNOA is typically about 30% making it looking very profitable. But that’s because its brand is not on the balance sheet. And so with a mature pharmaceutical company with income from its R&D but the R&D investment not in the denominator of RNOA.
- Investments not booked to the balance sheet, like R&D and brand investments, are expensed against income in the numerator, reducing the RNOA measure. That’s the case with an early-stage pharmaceutical firm with large R&D expenses but little income as yet. (Under IFRS, only R is expensed, not D).
These features are of courses due to how the accounting works. A measure of the rate of return on investment ideally compares the return to investment (in the numerator of the calculation) to the amount of investment (in the denominator), a measure that appropriately separates stocks from the flows they generate. That measure of “real” profitability is the one that economists have in mind and the interpretation often made in profitability analysis. However, accounting profitability mixes stocks and flows. Some investments are charged against earnings in the numerator, mixing investment with the return to investment, with the consequence that the investment is not in the denominator; accounting profitability is not economic profitability. This is increasingly so with much of investment now days in so-called intangible assets that are expensed against earnings: Research and development (R&D) expenditure, brand building, investment in supply chains and product distribution systems, customer loyalty programs, human capital, organization and start-up costs, and software, to name a few. Taking the measure at face value, low profitability is judged as poor investment performance, but that is not necessarily so if it is reduced by expensed investment that potentially generates profitability.
Are accountants mad? No, there is method in the madness. The accounting is a reaction to risk (in R&D investments, for example): Don’t book very risky investments to the balance sheet with the pretense that they provide collateral. This is called conservative accounting, an appropriate name in the face of risk: Be conservative, be prudent. Chapter 6 mentions this, but it is taken up in earnest in chapter 8 on risk. There you see how informative the accounting for RNOA is, telling you about the risk of investing. So, a low RNOA due to expensed R&D, as in the early-stage pharmaceutical start-up, indicates a risky investment: The R&D may not pay off. In terms of the accounting criterion for recognizing assets, the “probability of future benefits” is relatively low. Correspondingly, a high RNOA is relatively low risk: The (R&D) asset is not in the denominator but the (R&D) investment has paid off: Income realized; risk resolved. Coke, with a high RNOA, is low risk.
There are further reasons for the warning to beware of profitably measures:
- A manipulative accountant can create a high RNOA by writing down assets excessively. These assets become future expenses (like cost of goods sold, depreciation, and amortization) so writing down assets will reduce future expenses, yielding higher profits.
- A merger or acquisition will almost always yield lower RNOA for the combined companies.
Chapter 6 explains.
