capitalizing, expensing and the internet (ii)

Back when I entered the stock market, and when the CFA Institute was run by professional investors, that organization published an industry-by-industry guide to securities analysis written by veteran industry specialists.

The section on technology was a real eye-opener.  It was a litany of virtually every accounting fraud known to man.  The abuses ran in two related areas:

–capitalizing (and therefore delaying recording as expense) almost everything, especially research and development expense, and

–setting unrealistically lenient schedules for depreciating or amortizing these balance sheet accounts.

The result (and intent) of this chicanery was income statements that showed profits far in excess of the “real” amounts–even paper “profits” when a company was actually bleeding red ink.

The abuses were so blatant that the accounting rules were changed in the US to force virtually all companies to expense R&D costs as incurred, rather than store them up on the balance sheet.  Virtually all companies still write off against income the cost of their plant and equipment much more slowly in their financial reporting to shareholders than they do in their tax reporting to the IRS.

Fast forward to the present.

What effect does the long-ago change in accounting rules for R&D have on today’s publicly traded companies?  For hardware-dependent firms, not that much.  Yes, computers may wear out or become obsolete much faster than, say, a cement plant.  But the presentation of profits to actual and potential shareholders of a semiconductor foundry, a server farm or a steel mill allow for a more or less apples to apples comparison.

Not so for software-oriented firms.

Let’s take AMZN as an example and do a back-of-the-envelope calculation.

During the first half of 2013, AMZN spent $2.97 billion on technology and content.  If we assume that all of that were capitalized instead of expenses (an aggressive assumption) but that any resulting financial reporting profits were subject to tax at the very-high US rates, then I figure AMZN would have shown earnings of $4.50 per share so far in 2013 instead of the $.46 actually reported.  This would suggest, in ballpark figures, $10 a share in EPS for the full year.

Maybe the multiple isn’t so crazy.

Just as important, the same adjustment should apply to any other R&D-centric firm.   R&D may be creating important long-term intellectual property assets for a company, but the accounting rules (for sound historical reasons) portray this activity as a minus.

 

 

capitalizing, expensing and the internet (i)

finitude and stocks

I’ve been having memento mori thoughts recently.

No, not about me personally or anyone I know.  Instead, I’ve been thinking about the role of value investing in today’s world.

Several things have turned my mind in this direction:

–as I travel, I can’t help but notice the increasing numbers of businesses that are giving up the ghost in rural and suburban areas–restaurants, inns, whole strip malls either shuttered or never opened

–I realize that I’m part of the problem as, to my wife’s dismay, I order increasing amounts of stuff through Amazon

–I sometimes wonder what investors are thinking when they pay over $300/share for AMZN, a company whose book value is under $20 and whose high-water mark for earnings was $2.53/share, pre-Great Recession.  Don’t misunderstand me–I’m not saying there aren’t reasons for buying AMZN (after all, I own SPLK (Splunk–great name).  I don;t own AMZN, though.).  I just wonder whether people have thought through what they’re doing or whether they’re just going with the flow.

value investing

What does this have to do with value investing?

When a company spends money, it has two basic choices about how to account for the expenditure.  It can:

–record the money as an expense against current earnings.  In this case the money appears on the income statement as a cost–e.g., raw materials, marketing expense, salary…–and then disappears forever, or

–record the spending as an asset on the balance sheet and dribble the amount as a cost into the income statement over a long (possibly very long) period of time.  The fancy name for this process is capitalizing and it’s normally done only with assets that have long useful lives, like office buildings, stores or factories.  (The company will disclose the rules it uses for the gradual writeoff of asset value in the footnotes to its financial statements.)

The money has already left the building in either case.  The difference is a decision about what revenues to use to match what costs to.

is capitalizing a problem?

I think so.

Value investors like to look at per share book value (also called shareholders’ equity, or net asset value)–i.e., the value of the assets listed on the balance sheet minus any liabilities–and compare this with the stock price.  They consider a stock trading at a discount to book value to be a potential bargain and one trading at a premium (or, like AMZN, at 15x book!) to be potentially overvalued.

The rationale behind this is that:

–the asset base is a defense against competition.  A potential rival would presumably have to spend a similar amount just to enter the business.

–book value is based on the actual prices paid, and is not adjusted for inflation.  A company with a long history may well have assets whose value has increased over time but whose cost has already been partly or completely written off against income.  Therefore, book value may significantly understate the actual value of the company’s assets.

I have two concerns

In the current time of deep social and technological change, having a lot of capital sunk into yesterday may not be such a great thing. After all, it didn’t help Toys R Us or Borders or Circuit City.

Also, my experience is that US companies are very reluctant to decrease the balance sheet value of not-so-hot assets.  And auditors are not inclined to push the issue.  The more dead real estate I see, the more I wonder whether corporate balance sheets are as up-to-date as they’re supposed to be.

 

Amazon is the polar opposite of the book value enthusiast’s ideal stock.  How much of that is reality, how much accounting quirks?  That’s tomorrow’s topic.