Gavekal Capital: A Discussion On Return On Equity

Tuesday, April 14, 2015

A Discussion On Return On Equity

One the primary reasons we adjust financial statements to include intangible assets is have a more realistic lens to view every company with. Investment in intangible assets such as R&D, employee training and brand equity create sustainable, competitive advantages that result in higher market share and pricing power. This is accomplished by the fact that intangible investments create a unique capital stock which generates future profits. When intangible investments are treated as an expense rather than as an investment, it distorts certain operating metrics that analysts rely upon by understating current profits, understating long-term assets, and understating retained earnings. Current period profits are understated because all investments in intangible assets are expensed on the income statement. This lowers current period (taxable) net profits and also reduces retained earnings under shareholder equity. Long-term assets are understated because intangible investments are never capitalized onto the balance sheet and never carried at depreciated, historic cost. Consequently, important "flow to level" operating ratios such as return on assets (ROA) or return on equity (ROE) are unrealistically inflated.

Let's take a look at this effect on a company level using Gap (ticker: GPS) and then the effect on aggregate sector data for the MSCI World Index.

Gap is global apparel retail company founded in 1969 in California. Gap has gross margins of around 38% and generates a free cash flow margin of 8.6%. Gap has been a pretty steady company over the past 20 years managing to grow sales per share, EPS, book value per share and cash flow per share by about 9-10% per year on least squares growth basis. Gap also currently has a 2.2% dividend yield. As these numbers indicate, Gap is undoubtedly a mature company that would never be classified as a "growth" stock. Given all of this, does it make any sense then that Gap currently has an ROE of 42.3%?

Let's go back to our CFA textbooks and remind ourselves what makes up ROE under a DuPont Analysis framework. ROE is made up of net profit margin (net income/sales), asset turnover (sales/total assets) and financial leverage (total assets/total equity).  In the table below is Gap's DuPont Analysis using Gap's "as-reported" data.

As-Reported ROE Calculation

Now let's view Gap through an "intangible-adjusted" lens. In the table below, we again show Gap's DuPont Analysis but this time including intangible investments. First off, you notice that ROE drops by nearly half to a much more realistic, but still impressive, 23.6%. We see that net profit margin increases by 20 bps from 7.7% to 7.9%. Net profit margin increases because we are no longer expensing current period intangible investments. However, net profit margin is also brought down by the greater amount of depreciation expense from prior periods intangible investments. Asset turnover decreases by over 28% has Gap's long-term assets as a percent of total assets increases from 36% to 52% with the capitalization of intangibles investments. Lastly, financial leverage decreases from 2.6x to 1.9x. This is caused because shareholder equity is revised upwards from just under $3 billion to over $5.5 billion. Total assets also increase from $7.7 billion to $10.2 billion. Overall, a ROE of 23.6% passes the smell test much easier than 42.3% given everything we know about Gap.

Intangible-Adjusted ROE Calculation

If we broaden this discussion out and look at sector level data, we see ROE ratios that are much more in line with a slow, but growing, global economy. All sector data is looked at on a USD, equal-weighted basis. Overall, ROE levels drop from about 18% for the MSCI World Index to about 12% on average. ROE in consumer dominated sectors drop back the most. As these companies spend quite a bit on brand building and non-scientific R&D, it makes sense that they would have a very large asset base that currently goes underappreciated when looked through the lens of "as-reported" data.

As-Reported ROE Calculation By Sector

Intangible-Adjusted ROE Calculation By Sector

The proper treatment of intangible investments in financial statements is becoming more imperative as businesses shift away from classic fixed capital investment to knowledge based, intangible capital investment. Every year more intangible capital is created by innovative companies, and every year since 1974, due to SFAS No. 2, this capital base is completely missed by the greater financial community. This information mismatch creates an alpha opportunity for investors who know where to look.