Why S&P 500 Earnings May Be Understated

Over the last half century, the global economy has shifted from one broadly built on tangible assets, such as factories or trucks, to intangible, or nonphysical assets, including brand building or employee training. This has made it more complicated to interpret the financial statements of companies that concentrate on intangibles. Distinguishing between companies losing money for justifiable reasons and real losers is also difficult.

Accounting conventions are at the root of the problem because they treat tangible and intangible investments differently. Today’s standards fail to provide the information that managers and investors need to make knowledgeable choices about a company. So what should investors do?

A simple way to think about valuation is to separate a company’s results into two piles: earnings and investments. Accounting conventions can make figuring out what goes into which category tricky and misleading.

Tangible investments for a given period show up on the statement of cash flows, and their cumulative amount shows up as assets on the balance sheet. Intangible investments, however, appear as an expense in the selling, general and administrative (SG&A) section of the income statement. Intangible investments are recorded on the balance sheet only when they are acquired. Absent an acquisition, intangible investments are reflected solely as an expense.

Here’s an example: Company A buys a machine for $1,000 that has an estimated useful life of five years. The present value of expected cash flows is $1,500. Company B spends $1,000 to acquire a subscriber who is expected to remain a customer for five years. The present value of the customer’s expected cash flows is $1,500. The economic profile of these investments is identical, but their accounting treatment is different.

Company A records the machine as property, plant and equipment on the balance sheet and depreciates it $200 a year for five years. Company B immediately reflects the $1,000 customer acquisition as an expense in the SG&A section of the income statement. Note that Company B will “lose” more in earnings the faster it grows, even though acquiring customers can create value.

Allocating intangible investments to the investments pile vs. the earnings pile shows why multiples of earnings or cash flow, which are a shorthand for a proper valuation process, come up short in the task of discerning value and value creation. This is important, because a survey of almost 2,000 professional fundamental investors shows that nearly 93% use multiples to value businesses.¹ The most popular multiples are price-to-earnings (P/E)² and enterprise value-to-earnings before interest, taxes, depreciation and amortization (EV/EBITDA).³ Simply stated, if earnings or EBITDA are not adjusted to reflect intangible investments, assigning a multiple may yield an estimate for price or enterprise value that is incomplete or misleading.

One solution is to record a company’s intangible investments on the balance sheet rather than on the income statement and to amortize them over their useful lives. This treats an intangible investment the same as a tangible investment.

We applied this approach to the financial statements of two companies, one in an intangible-intensive industry and the other in an industry dominated by tangible investment. The adjustment was significant for the first one and inconsequential for the second.⁴ The operating profit margin of the first company expanded by more than 15 percentage points after recategorizing the substantial intangible investments as assets. There was an insignificant change for the second company that invested primarily in tangible assets.

When our team made these adjustments for the S&P 500, the EBITDA margin and operating profit margin rose 1.5 percentage points and net income was nearly 12% higher than what was reported.⁵

The Bottom Line? Investors should be careful when they use historical multiples to value the market today. Sorting the earnings and investment piles more accurately leads to a different conclusion about both earnings and investments while leaving total cash flow unchanged. This is important, because the rote application of multiples that prevailed in the past risks underestimating the significance of the shift from tangible to intangible investment.