Undue management flattery
I’ve just checked and Moody’s Corporation (MC) is showing a five year average return on capital (ROC) of 312.86% compared with its cost of capital of 11.25% and a current price to book ratio (P/B) of 114.3. Are management geniuses or are the numbers misleading us?
Warren Buffett tells us: “The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share. Many businesses would be better understood by their shareholder owners, as well as the general public, if the managements and financial analysts modified the primary emphasis they place upon earnings per share and upon yearly changes in that figure.” (The Essays of Warren Buffett: Lessons for Corporate America. New York: Lawrence A. Cunningham. 1998, p.170)
I would modify Buffett’s ‘high earnings rate on equity capital employed’. It’s better to use return on capital. The idea of ROC is to assess the return generated from the capital employed in the business, whether equity or debt. That is, we want to know what return the business is capable of generating on the total capital whether it is made up of pure equity or mixed equity and debt.
Companies that produce a great ROC, well in excess of their cost of capital, tend to generate Owner Earnings. Owner Earnings is a Warren Buffett term and roughly equates to free cash flow. As well, a substantial spread between ROC and a company’s cost of capital over an extended period of several years and through business cycles is usually indicative of a sustainable competitive advantage; in other words, a moat. Finally, high ROC companies tend to be companies that have opportunities to reinvest excess capital at high rates of return.
We can say, quite simply, that companies that cannot produce substantial Owner Earnings year after year are, with limited exceptions, not worth investing in no matter how quickly they are growing sales and earnings.
There is a significant fly in the ROC ointment. As noted earlier (The fading usefulness of book value), we live in an age of increasing intangible assets not shown on balance sheets and increasing intangibles investment being expensed. This has significant consequences for interpreting ROC. In the most generic sense ROC is the profit earned by the business divided by the total of financial capital employed in the business and expressed as a percent. The financial capital is comprised of both debt capital and equity capital.
Some analysts exclude the book value of goodwill and intangibles from assets on the theory that intangible assets and goodwill don’t need to be replaced and that tangible assets provide the most reliable indication of the company’s assets. In the writer’s view it is a complete fallacy to exclude intangibles and goodwill. They may possess lasting economic value and are being used by management to generate earnings. Management and company performance need to be judged on all the capital employed.
But that’s not the main problem. Most analysts fail to include Economic Goodwill as part of a company’s assets. Management have stewardship over three categories of assets: (1) tangible assets, (2) intangible and accounting goodwill assets both of which are shown on balance sheets and, (3) intangible assets in the nature of economic goodwill not shown on the balance sheet.
Management gets a free ride on a substantial part of the company’s economic goodwill.
Warren Buffett says: “…You can live a full and rewarding life without ever thinking about Goodwill and its amortization. But students of investment and management should understand the nuances of the subject. My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic Goodwill. This bias caused me to make many important business mistakes of omission, although relatively few of commission.” 1983 Berkshire Hathaway, Chairman’s letter to shareholders, quoted in (Buffett, 1998)p. 171.
This was written before the 2004 change in the accounting treatment of goodwill. The fact that more goodwill remains on balance sheets today makes it even more important to understand what Buffett is saying.
Warren Buffett make a clear distinction between economic goodwill and what he calls, ‘spurious accounting goodwill.’ (Buffett, 1998) p.176. He defines economic goodwill as follows: “Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic Goodwill.” (Buffett, 1998) p.173. Readers should note that intangible and accounting goodwill assets shown on balance sheets may be included in a proper calculation of economic goodwill.
Buffett goes on: “Ultimately, business experience, direct and vicarious, produced my present strong preference for businesses that possess large amounts of enduring economic Goodwill and that utilize a minimum of Tangible Assets”. (Buffett, 1998)p.171.
To return to the question we started with; are management of Moody’s Corporation (MC) absolute geniuses to produce a return on capital of over 300% the last five years? They may be outstandingly competent, but ROC of over 300% doesn’t prove it. The simple fact is that the management has the use of very substantial intangible assets in the nature of economic goodwill that should be taken into account. If the company were sold, those intangible assets could be realized on even though they don’t appear on the balance sheet.
The next time you are looking at a company with a ROC of 15, or 20 or 25 and a cost of capital of 10, ask yourself if this is simply a reflection of economic goodwill not shown on the balance sheet. One way to check this is to look at the free cash flow yield based on the market price. It’s best to do a weighted average of the last three years of free cash flow (weighted to TTM).
This is a big issue. Something over 80% of the market capitalization of the S&P 500 is made up of intangibles. Only a fraction of that appears on balance sheets.
Want to read more about the issues raised in this post, take a look at Chapter 35. Capital Structure, Strength and Economic Performance and specifically Sections 35.05 Accounting Goodwill and Economic Goodwill and 35.16 Measuring Economic Performance and the Sections that follow. More generally, take a look at Part 6: The Hallmarks of Superb Businesses.
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