In his latest paper titled – Good Losses, Bad Losses, Michael Mauboussin explains why investors must look past simple measures of profits to understand a business’s true ability to create value. Here’s an excerpt from the paper:
Accounting is the language of business that allows a company to share its financial results with interested stakeholders. Certain principles guide how accountants reflect the range of business activities on financial statements.
One principle of accounting is conservatism, which says that companies should be prudent when recognizing items that have uncertain future benefits. For example, the Financial Accounting Standards Board issued the Statement of Financial Accounting Standards No. 2 in October 1974 that stipulated that research and development costs, a classic form of intangible investment, should be expensed immediately because of “a high degree of uncertainty about the future benefits of individual research and development projects.” Today, most intangible investments are subject to this principle.
The rise of intangibles in recent decades means that more investments than ever are expensed immediately versus capitalized on the balance sheet and amortized on the income statement consistent with the principle that sales and expenses should be matched over time.
This makes the income statements and balance sheets of today appear distorted relative to those of the past. In particular, some businesses with high return on investment have losses. Academics call these companies GAAP losers to distinguish them from real losers, businesses that have expenses unrelated to investment that exceed sales.
Capitalizing intangible investments and amortizing them makes the economic picture clearer. It allows investors to sort companies losing money for the right reasons and improves the relevance of earnings. Core concepts are communicated more clearly.
Evidence from recent decades shows that GAAP losers produced attractive total shareholder returns relative to the real losers and profitable companies. Investors must look past simple measures of profits to understand a business’s true ability to create value.
You can read the entire paper here:
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