Tag Archives: Clean Surplus

A Reader’s Question on ROIC and MROIC, Goodwill and Clean Surplus Accounting

S.A. Nelson’s little book, The ABC of Stock Speculation, cites the basic opportunity for manipulation in these words: “The great mistake made by the public is paying attention to prices instead of to values.” What do we mean by paying attention to prices rather than values? Human nature is one of the few constants in an ever-changing world:  “It is only fair to say that the public rarely sees value until it is most markedly demonstrated to them, and the demonstration comes generally at a pretty high price. It is easier for them, as experience shows, to believe a stock is cheap when it is relatively dear, than to believe it is cheap when it is more than cheap.”

A Reader Asks about ROIC and MROIC (Marginal Return on Invested Capital)

I have been thinking about return on capital. My understanding is that one thing Greenblatt is trying to do come with in his Magic Formula is an incremental return on capital – that’s why he excludes things like goodwill. He’s arguing that it’s the return he can get on the assets that actually exist that’s important.

JC: True

I’ve expressed scepticism about this before, arguing that increases in earnings often come through acquisitions, and therefore goodwill was/is a true capital cost (if the company didn’t need to spend money on goodwill, then why did it?).

Well, this got me to thinking – if what you’re really trying to ascertain is a company’s incremental return on capital – then why not CALCULATE an incremental return on capital, rather than some surrogate? The formula is simple enough (and nothing new, I didn’t invent the idea):


There are some nuances, like whether you want to use EBIT figures or net income, adjusting for share issues, and so on. But you could use something like EBIT in the numerator, and total capital in the denominator.

What are your thoughts on this?

JC: You should look at a company both ways. What are the returns on the net tangible assets employed AND what are the incremental returns on capital employed in the business.  We only have a few more chapters in Competition Demystified and then I will begin a long series on valuation-the death march.

For now, you may get some insight here:Dale Wettlaufer on ROIC and MROIC, EconomicModel of ROIC_EVA_WACC and ROIC and the Networking Industry.

You are not the only investor to be skeptical about IGNORING GOODWILL. See page four in this article:Why bad multiples happen to good companies. Cisco (CSCO) CSCO_VL, for example, has a high ROIC–so you will find it on http://www.magicformulainvesting.com/welcome.html but much lower ROC (Return on total capital) due to many acquisitions that were acquired with goodwill. Yes, investors are laying out real dollars, so you need to track the success over time (rolling average of a few years) of those acquisitions.

Question on Clean Surplus Accounting

OK, very interesting John. I’m reading the book Book-on-Buffett-Methods-of-Clean-Surplus . I’ve only got to page 65, but I’m seeing the idea. The author uses a LOT of words to describe a very simple concept.

JC: Agreed. The author says in 230 pages what he could say in 3.

What’s very interesting is that by stuffing a lot of so-called one-off charges through the P&L, a company is able to “juice” its returns for the year, creating an artificially high ROE for subsequent years. Does it mean that clean surplus accounting paints too rosy a picture of a company? The answer is: probably not. With clean surplus accounting, all that “juicing” gets accumulated into the retained earnings of the company, so that in subsequent years, assuming the absence of further exceptional items, returns will actually come out lower. So in effect, clean surplus accounting isn’t being fooled by these non-recurring charges into over-estimating ROE.

The drawback seems to be that you have to go back into the mists of time to find out what the true retained earnings should be, and scrupulously adjust for capital issues, and suchlike. To make matters worse, you need a good set of accounts, which you can probably only get for 5 years. Sites might give you net income, but they wont give you comprehensive income – information which you need to see what’s been shifted around where.

JC: Well, once you are interested, you can always go back at least ten years with the SEC filings.  Also, watching margins, buybacks, prior use of capital allocation can give you a further clue. Also, how clean is their accounting? Track what management says vs. what they do.  You have to put together a mosaic on the company.

Also, what’s you view on goodwill? Should it be treated as a non-recurring charge?

JC: No, because some businesses like Cisco (CSCO) or Seacor (CHK) are making acquisitions as part of their ongoing operations. Better to understand the particular business rather than apply a one-size-fits all approach.

What about exceptionals that seem all-too-frequent? Would you treat them all as non-recurring, or might you assign a proportion as recurring, and a proportion as non-recurring? Maybe you could say a proportion of sales would count as non-recurring, and a proportion as recurring. Maybe you could take a proportion as recurring – say 20% – and the rest non-recurring. You could, of course, argue that over the long term, all exceptional items are recurring to a first order of approximation.

JC: I am a little lost on this question. Can you provide an actual example? In the end, you are trying to get to “normalized” earnings. What is the basic owner’s earnings (cash you can take out of the business without hurting the business in its competitive environment). Many businesses are too tough to figure out what their normalized earnings will be so you walk away. There is a reason why Buffett invests in a chewing gum company (Wrigleys) and not Microsoft. He wants to know where the business will be in ten years. People will still chew gum but will they still increase their use of Microsoft Office?  I am not implying that you not invest in Microsoft–just be ware of the risks in your assumptions.

JC: We will have a long, brutal slog in analyzing how to value growth in a few weeks. You have to know this as an investor, but the real fun is in understanding a business so you can have some confidence in your assumptions.

Thanks for the questions.

Investment Methodology for Investing in Franchises

“To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses – How to Value a Business, and How to Think About Market Prices.”

“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.” (1996 Chairman’s Letter–Warren Buffett

Franchise Investing

Many weeks ago I mentioned and posted a book on using clean (taking out the “dirty” stuff like one-time accruals) surplus accountinghttp://wp.me/p1PgpH-Fx

The gist of the method is to use clean surplus accounting to calculate the company’s true return on equity that makes it easily comparable to other companies. Then invest (at the right price) in companies with better than average ROEs than the market’s average ROE (13%) if you want to outperform an index of stocks.

Obviously, if a company sports a relatively consistent ROE above 15% without too much debt, then the company probably operates with competitive advantages.

Learn More

For those who wish to learn more: You can listen to radio segments http://www.buffettandbeyond.com/radio.html of the promoter of “Buffett and Beyond.” Yes, a bit promotional, but the concept the Professor is explaining is sound.

For a list of companies that fit the investment parameters go here: Parameters_for_Investing_the_Buffett_and_Beyond_way

A consolidation of past articles: Clean surplus article

If you have a method that makes sense, you know how it works, and you have confidence in its LONG RUN performance, then you are better off than 99.9% of all investors in the market.

I am not promoting the above method as THE best way to invest, just suggesting that you develop your own investment philosophy and method that YOU believe in. This post is just an example of how you might go about developing your method.