Market-Expected Return on Investment

Posted on April 15, 2021 by Florian Buschek

Bridging Accounting and Valuation

Another paper from Michael Mauboussin and another good one. They discuss the role of intangibles and the issues that arise when investments in those via SG&A are not properly capitalized on the balance sheet. Intangibles are becoming more and more important these days

…and most of them are not even properly accounted for. The paper walks through some examples of how to infer the return investors are demanding from those investments in intangibles.

and how it changes return indicators such as Return On Invested Capital.

Investors generate excess returns when they buy the shares of companies prior to a revision in expectations
about future cash flows. A key determinant of cash flows is a company’s ability to allocate capital to
investments that create value. The current principles of accounting do a poor job of separating investments
and expenses, creating a veil that obscures the magnitude and return on investment.27 A key job as an
executive or investor is to adjust financial statements so as to lift the veil and understand the economics of the
This report fills the gap between accounting and valuation by defining MEROI, providing guidance about how
to separate SG&A costs into investment and expenses, and reviewing the limitations of popular measures of
return. None of this changes a company’s cash flow, of course, but clarity into investment and return on
investment provides a sound basis for assessing expectations.
The global economy has undergone a substantial change in the past few decades, with intangible investments
now dominating tangible ones. But our financial statements and traditional valuation techniques struggle to
capture these changes. Thoughtful investors go the extra step to understand what expectations are priced into
a stock and whether the company is likely to meet those expectations.

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