In his latest paper titled – Market-Expected Return on Investment (MEROI), Michael Mauboussin explains why MEROI, which measures the return at which the present value of a company’s profits equals the present value of the investments a company makes, is a better measurement of corporate returns that the traditional measurements of ROE, ROIC, ROIIC, and IRR. Here’s an excerpt from the paper:
Investors earn excess returns when they correctly anticipate revisions in expectations for future cash flows. To find mispriced expectations, investors must understand the potential magnitude and return on investment.
This report seeks to help executives and investors in three ways. First, we describe market-expected return on investment (MEROI), which measures the return at which the present value of a company’s profits equals the present value of the investments a company makes. An understanding of MEROI allows us to understand how high the bar is set for corporate performance.
Second, we note that measuring returns has become more difficult as corporate investments have shifted from being primarily tangible to intangible. Because intangible investments are recorded as expenses, the categorization of expenses and investments is blurred. We seek to gain a more accurate view of returns, and hence expectations, by separating expenses and investments properly.
Finally, we discuss the shortcomings of common measures of corporate returns, including return on equity (ROE), return on invested capital (ROIC), return on incremental invested capital (ROIIC), and internal rate of return (IRR). While these measures have some utility, they are commonly used without full acknowledgment of their limitations.
The connection between valuation (MEROI) and accounting (properly measuring intangible investment) is what makes this report novel. Some of the following discussion is technical, but the underlying concepts are straightforward and are illustrated with examples and a case study.
You can read the entire paper here:
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