The accounting measures of profitability (book rates of returns) in chapter 6 come with a warning: Beware of Paying for Profitability. Accounting profitability is not a measure of economic profitability and interpreting it as such is a trap. The chapter explains why the two differ and why those differences actually enhance the information conveyed by accounting profitability if they are understood. That redeems the measure as a key one for valuation. The chapter also explains how to incorporate the profitability measures in valuation with the reminder: Carry the balance sheet with you. That protects you from paying too much for profitability.
The chapter also points to deficiencies with other profitability measures, more traps. But a number of commentators have pushed back on the accounting profitability measures we adopt, ROE (levered) and RNOA (unlevered). Here are some misconceptions about accounting profitability measures with a reply:
- Earnings are overstated due to inflation.
No: An investor wishes to understand the effects of inflation on a firm and looks to earnings to observe that effect. Does the firm have a hedge against inflation? Some firms can raise selling prices easily with inflation, increasing earnings and providing inflation protection. Reducing earnings for inflation takes out that information, reporting value lost during inflation versus value preserved.
- As accounting does not adjust for inflation, profitability is overstated: Earnings that incorporate inflation (with higher nominal revenues) are compared to net assets that are not restated to for inflation. Earnings and assets have to be on the same (purchasing power) dollar basis.
No: This is a misconception. Assets are investments to gain revenues and earnings so the lower the price paid for the assets the higher the rate of return on that investment. For example: Inventory is purchased for 100 but currently would cost 120 with inflation; earnings of 20 are higher because of inflation, so the book rate of return is 20% rather than 0% with the inflation-adjusted inventory. The 20% gives recognition for buying inventory at 100 rather than 120, adding value. The firm has timed inventory purchases: Buy low, Sell high. The same applies to property, plant, and equipment: a lower investment cost means lower depreciation expense and higher profits with inflation.
There is a further point: Revaluing inventory or plant upwards for inflation and recognizing the corresponding gain in income would report that inflation adds value. But inflation typically damages firms and their stock prices. See chapter 8.
Yet another point: Accounting reports nominal profits and nominal book rates of return. In valuation, the earnings value added over book value (net assets) is charged with a nominal required return and that includes risk from unexpected inflation (see chapter 8 again): The value added is discounted for the risk to inflation.
- Accounting profitability measures do not put all investments on the balance sheet (R&D, for example). Thus book rates of return denominated in balance sheet assets are overstated.
No: Chapter 8 goes to lengths to explain why very risky investments are not booked to the balance sheet with the effect that the profitability measures convey risk to the investor. The operating principle is conservative accounting when faced with high risk, Good accounting for risk. (85% of R&D is unsuccessful, we are told.)
