Recasting Expenses As Intangible Assets For ROIC

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One of the things that can really screw up an ROIC analysis (not to mention a valuation using some kind of income multiple using the income statement) is a failure to be thoughtful about intangible investment and where it is vs. where it should be in the financial statements that are used to get to ROIC.  As discussed here, intangible investment is far more prevalent now than it was decades ago because businesses of every kind – not just tech – are digitizing their operations.  Everything from how employees work together to acquiring customers and interacting with them is becoming digital, and the assets that enable those interactions are intangible.  

Yet, GAAP ignores this reality and treats almost all money a business spends on things other than tangible assets as expenses (income statement), not investments (balance sheet).  That’s because it was created for a world where all investment is tangible, like building a new factory to make more widgets.

But what about something like R&D? Clearly that is an “investment” in future products and therefore revenue, even though it does not produce anything tangible.  Under GAAP 100% of the R&D expenditure is recognized in that period via the income statement, and there is no impact on the balance sheet.  In accounting terms, the expensing of R&D seems to violate the matching principle, because it is not matching future revenue with the expense that created it in those future periods. The best explanation for why GAAP takes this approach is the conservatism principle, which argues that because future benefits from R&D are so uncertain, the prudent thing to do is to just recognize them all in the current period.  There is a fair amount of discussion of this among academics and it’s beyond the scope of this blog. 

But the bottom line is that for both valuation and capital productivity purposes we may want to recast intangible investment such as R&D from the way it is treated under GAAP financials. We could remove this investment from the income statement where it shows up as an expense, capitalize it on the balance sheet (reducing it each period by its amortization), and put the amortization of that investment over its useful life back on the income statement. This is viable for R&D, but also other income statement items like Sales & Marketing, and General & Admin. If doing this would more closely reflect the economic reality of the business, why wouldn’t we do this?

Further, we could also make parts of these items investments while other parts remain operating expenses. For example, let’s say 20% of Sales & Marketing expenditures are on keeping current customers happy, while 80% is based on finding new customers. Can we recast the 80% as an investment and keep the 20% as an expense? And why would we do this, again? Because it changes NOPAT and invested capital levels in the ROIC ratio to more closely reflect the underlying economics of the business.

Smart investors do this recasting exercise when looking at companies, especially growth-oriented tech companies that invest heavily in subscription customer acquisition, and it’s a tool you should have in your toolbag. I am going to get into exactly how to do it in the next post by walking through a hypothetical example in Chapter 24 of McKinsey’s Valuation 7th Edition.

Please email me with questions/comments/errors related to this post!

Please email me with questions/comments/errors related to this post!