Market-Expected Return on Investment Bridging Accounting and Valuation

A failure to account for  intangible investment can lead to distorted, or even nonsensical, ROICs.

ROE, defined as net income divided by shareholders’ equity, is massively distorted by the rise of intangibles. Net income has always been unreliable because of the considerable discretion management has in reportingexpenses within accepted accounting principles. Shareholders’ equity has also lost relevance because of the  vagaries of accountin... See more

The difference between the unadjusted and the adjusted MEROI is a function of what percentage of SG&A isreclassified and the assigned amortization period. (See the appendix for a more detailed discussion.) If noSG&A is considered to be an investment, no adjustments are necessary. The higher the percentage of SG&A  that is capitaliz... See more

Businesses with high returns often fetch  lofty valuations, which is why great businesses are not always great stocks.

Luminita Enache and Anup Srivastava, professors of accounting, developed a technique to measure intangible  investments.10 They separate reported operating expenses into two groups. The first is intangible investments  that include R&D and advertising. The second is selling, general, and administrative (SG&A) expenses  exclud... See more

Sorting expenses and investments was easy whenmost of the expenses were on the income statement and most of the assets were on the balance sheet. Butcategorization is a challenge today because income statements conflate expenses and investments.  One consequence of the shift to intangible investments is that more companies are reporting negati... See more

There are three steps in estimating MEROI in practice. First, you create a discounted cash flow model thatreflects the expectations embedded in the company’s stock price.8 Second, you calculate the present value of  investments discounted at the cost of capital. And finally, you solve for the breakeven rate that equates the  present value... See more

If a company earns exactly its cost of capital on its investments, the present value of incremental NOPAT and  the present value of investment will be equal. SVA and PVGO are both zero.

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.