The
Little Book of Valuation The
Little Book of Valuation
While R&D expenses are the most prominent example of capital expenses being treated as operating expenses, there are other operating expenses that arguably should be treated as capital expenses. Consumer product companies such as Gillette and Coca Cola could make a case that a portion of advertising expenses should be treated as capital expenses, since they are designed to augment brand name value. For a consulting firm like KPMG or McKinsey, the cost of recruiting and training its employees could be considered a capital expense, since the consultants who emerge are likely to be the heart of the firmÕs assets and provide benefits over many years. For many new technology firms, including online retailers such as Amazon.com, the biggest operating expense item is selling, general and administrative expenses (SG&A). These firms could argue that a portion of these expenses should be treated as capital expenses since they are designed to increase brand name awareness and bring in new presumably long term customers.
When
we capitalize the expenses associated with creating intangible assets, we are
in effect redoing the financial statements of the firm and restating numbers
that are fundamental inputs into valuation – earnings, reinvestment and
measures of returns.
1.
Earnings: As we have noted with all three
examples of capitalization (R&D, brand name advertising and
training/recruiting expenses), the operating and net income of a firm will
change as a consequence. Since the adjustment involves adding back the current
yearÕs expense and subtracting out the amortization of past expenses, the
effect on earnings will be non-existent if the expenses have been unchanged
over time, and positive, if expenses have risen over time. With Amgen, for
instance, where R&D expenses increased from $663 million at the start of
the amortization period to $3.03 billion in the current year, the earnings
increased by more than $1.3 billion as a result of the R&D adjustment.
2.
Reinvestment: The effect on reinvestment
is identical to the effect on earnings, with reinvestment increasing or
decreasing by exactly the same amount as earnings.
3.
Free Cash flow to the equity(firm):
Since free cash flow is computed by netting reinvestment from earnings, and the
two items change by the same magnitude, there will be no effect on free cash
flows.
4.
Reinvestment Rate: While the free cash
flow is unaffected by capitalization of these expenses, the reinvestment rate
will change. In general, if earnings and reinvestment both increase as a
consequence of the capitalization of R&D or advertising expenses, the
reinvestment rate will increase.
5.
Capital Invested: Since the unamortized
portion of prior yearÕs expenses is treated as an asset, it adds to the
estimated equity or capital invested in the firm. The effect will increase with
the amortizable life and should thererfore be higher
for pharmaceutical firms (where amortizable lives tend to be longer) than for
software firms (where research pays off far more quickly as commercial
products).
6.
Return on equity (capital): Since both
earnings and capital invested are both affected by capitalization, the net
effects on return on equity and capital are unpredictable. If the return on
equity (capital) increases after the recapitalization, it can be considered a
rough indicator that the returns earned by the firm on its R&D or
advertising investments is greater than its returns on traditional investments.
7.
Expected growth rates: Since the expected
growth rate is a function of the reinvestment rate and the return on capital,
and both change as a result of capitalization, the expected growth rate will
also change. While the higher reinvestment rate will work in favor of higher
growth, it may be more than offset by a drop in the return on equity or
capital.
In summary, the variables that are most noticeably affected
by capitalization are the return on equity/capital and the reinvestment rate.
Since the cost of equity/capital is unaffected by capitalization, any change in
the return on capital will translate into a change in excess returns at the
firm, a key variable determining the value of growth. In addition to providing us with more
realistic estimates of what these firms are investing in their growth assets
and the quality of these assets, the capitalization process also restores
consistency to valuations by ensuring that growth rates are in line with
reinvestment and return on capital assumptions. Thus, technology or
pharmaceutical firms that want to continue to grow have to keep investing in
R&D, while ensuring that these investments, at least collectively, generate
high returns for the firm.