The text of the link for lazy folks - long but perceptive IMO
To: lkj (5591 )
From: Robert S. Wednesday, Jan 20 1999 6:42PM ET
Reply # of 5637
As an occasional lurker on this thread (LU is in my core portfolio) I recall some discussion pertaining to LU's high PE. The following article may be of some interest:
BY Bernard Condon
01/25/99 Forbes Page 076
BY BEN GRAHAM's standards, Pfizer, FORBES' Company of the Year (Jan. 11), is no
bargain. It recently traded at 60 times estimated 1998 earnings and 16 times its book value
per share. But you can make the case that Pfizer's not so wildly overpriced with a little
conservative tweaking of the numbers. What if you ignore accounting rules requiring
Pfizer's R&D spending to be expensed right away and treat it more like an investment in
an asset generating wealth over the next five years? Pfizer suddenly appears to be trading
hands at 48 times earnings, some 20% cheaper, and at 12 times book.
The numbers we are accustomed to using for making investment judgments are
abstractions from reality. Critics of conventional accounting believe that they also distort
reality. Really smart investors must go back to the original data and reinterpret it. "Right
now," says former SEC commissioner Steven Wallman, "we take disaggregated data and
have accountants aggregate it, only to have investors disaggregate it again."
The old system served well enough when most assets were physical: plants and
equipment, ore or oil in the ground, real estate, trees, inventory you could count and money
that people owed you. But today the best assets are intangible: Microsoft's know-how and
market position, Dell's exclusive marketing setup, well-trained employees, a company's
reputation for quality or hipness.
For example, the Gap's value has little to do with the historical cost of its store fixtures and
everything to do with something accounting ignores: its brand image, based on a feel for
the market and carefully nurtured with advertising. Dell's computers aren't much different
from others, but its well-honed direct-selling system, though it doesn't even show on the
balance sheet, is an asset competitors lack. AOL's only substantial asset is its huge
subscriber base, but so far as accounting is concerned the money invested to build that
base was an expense, not an investment. How do you value such assets? The stock
market tries to. That's why some stocks sell at 8 times earnings and others sell at 40
times. The market recognizes--if the accounting rules don't--that the conventional
measures are inadequate.
Generally Accepted Accounting Principles--GAAP--says that money spent training staff
is an expense--money disbursed, never to be recaptured. But any business owner knows
that a well-trained staff is worth more than a state-of-the-art machine.
Wallman, now a senior fellow at the Brookings Institution, would like to see companies
supplement conventional reporting with additional material, prepared perhaps by someone
other than accountants. For example, he thinks it would be useful for investors to have
information about staff turnover rates, or have brand names valued by Interbrand or
American Appraisal. These outside appraisals would themselves be verified. The
Financial Accounting Standards Board could set standards for gathering information.
Auditors would check how companies came up with the data; the SEC would prosecute in
cases of fraud. Wall Street firms could manipulate the data to make up their own versions
of income statements and balance sheets. "For the first time in the history of accounting,"
Wallman says, "instead of having other people decide the rules, we could have
competition."
"The [existing] accounting system is failing us," says Amy Hutton, an accounting professor
at Harvard Business School. "The value is in the people, and that asset is not easily
counted. It's created a gap." So has heavy spending on research and development:
Witness Pfizer, which has shot to the head of its industry not because of size but on the
strength of its R&D and marketing programs. Pfizer's annual spending on R&D has
quintupled to $2.3 billion over the last decade, more than twice the growth in spending on
its property, plant and equipment. But this form of investment isn't captured on the balance
sheet. Neither is the value built into brand names by successful advertising and promotion.
Thus we get ridiculous numbers such as Coca-Cola's audited figures. They show that the
company regularly earns more than 50% on its shareholders' equity--seemingly impossible
to sustain. That's because neither its vaunted distribution system nor its brand name has
any value on the books. Based on accounting rules, Coke's assets are around $18 billion.
The stock market, of course, disagrees. It values Coke's 2.5 billion shares at $67 each,
pricing the company at nine times as much.
Who is right? Without making any judgment as to whether or not Coke stock is cheap, it's
still safe to say that the market is more nearly correct.
What would some of the high-flying companies look like if we treated their R&D as assets? Start with Lucent Technologies. If we capitalize R&D and then write it off over three years, similar to what we did with Pfizer, Lucent's earnings would rise by 27%. Its trailing price/earnings ratio would drop from 93 to 73. Motorola? Earnings would jump 55%, and the P/E would fall from 73 to 47.
As assets can be invisible to accountants, so can liabilities. When it went into its
downsizing program in the late 1980s, IBM showed a book value of $34 a share. When it
finished buying out unneeded employees and closing plants it no longer needed, book value
was down to about $19 a share.
In the real world, rather than that of accounting abstraction, IBM had an "invisible liability"
of something like $20 billion, and its stock suffered accordingly. GM, too, had its book
value almost wiped out--and its return on equity jumped--when it had to recognize more
retiree health benefits as a liability. The stock market recognized, if accountants did not,
that the fall of Communism had opened new worlds to American brands and greatly
enhanced their value. This went unrecognized on the books at Coca-Cola and Gillette and
in Hollywood, but it opened vast new markets to them and many other quality U.S.
brands.
"Ten years ago, if you were the chief executive officer of Coke, you were basically
[running] a Western company--North America, South America and Western Europe,"
says Michael Mauboussin, a food industry analyst at Credit Suisse First Boston. "Now you
have business prospects in India and the former Soviet Union that simply didn't exist ten
years before. You're seeing 4 billion consumers versus 1 billion consumers."
Conventional wisdom is that capitalizing R&D spending or advertising outlays is
aggressive because there is no way of knowing if the spending will ever pay off. But you
can say the same thing for most capital spending on plant and equipment. In the 1970s the
U.S. steel industry poured tens of billions into new equipment that became obsolete almost
as soon as it was installed. Yet the steel companies were showing healthy profits and the
new plants were carried as assets, though they turned out to be worthless.
The accountants are aware of the problem. FASB is holding meetings over the next year
and a half to come up with a list of nonfinancial data that companies would be
encouraged--but not required--to disclose. Paul Healy, an accounting professor at
Harvard Business School, points to the oil industry as a model for measuring
R&D. Oil companies capitalize all spending on drilling. If the hole is dry, only
then is the expense written off. If it produces oil, the capitalized costs are written
off over the life of the well. "If a company is unlucky in R&D this year, its stock
price can drop," he says. "But maybe you should have gotten clues about this
five years ago. How much was spent in the past that did not work out?"
Baruch Lev, an accounting professor at New York University, thinks Healy's idea doesn't
go far enough. He proposes that once an R&D project reaches the point at which you can
identify a product, say a drug that just passed Phase I tests, the product should be
recognized as an asset and all spending capitalized in the years they were expensed. If the
drug does not make it to market, you would go back and reduce earnings for the years the
money was spent. Historians, he points out, revise the past constantly; why shouldn't
businesspeople?
Nowhere are accounting rules more confusing than in mergers and acquisitions. Develop
a new brand and advertise it heavily, and you are expected to write off the expenses as
they occur rather than over the life of the new product. But buy a product by buying
another company and the cost becomes an asset. "If you develop something, it's
immediately expensed," explains Lev. "If you buy the same thing, it's not expensed and
you have an asset. This is nonsense." True, acquired goodwill must be written off over 40
years, but that's a lot different from writing it off immediately. Yet even this can be
avoided by arranging a pooling-of- interests deal wherein nobody gets acquired; the two
companies simply combine their balance sheets. Pooling boosts an acquirer's earnings and
distorts a key ratio--return on equity. In 1987 there were two poolings. Ten years later 500
were announced.
Note that whether one company buys another or they simply combine balance sheets,
nothing changes in the real world. But a lot changes in the world inhabited by accountants.
Yes, capitalizing franchises and R&D and employee training could be misleading and open
the way for book- cooking. But so do current accounting rules.
Hold it. Could all this talk be just so much bull-market revisionism, a rationalizing that
seeks new arguments to justify ever-higher stock prices? Jack Ciesielski, author of the
widely respected newsletter Analyst's Accounting Observer, calls it bull-market math.
"Now that P/Es are straining at the seams, we've got to find a way to justify it by saying
the messenger--accounting--is wrong. I don't buy it."
But critics of accounting like Steve Wallman aren't for scrapping the old rules. They want
to try out other measures, in part to give investors additional information, in part to
stimulate their thinking. A bit of history: In the very early 1980s the Walt Disney Co. was
not a particularly cheap stock by the standard measures, but it was nonetheless terrifically
undervalued. Because the company was poorly managed, investors weren't giving much
value to its rich and irreplaceable franchise. It only took smarter management to milk that
franchise, and for the value to be recognized by the market.
Had Disney been required to put a price on its franchise, investors might have recognized
sooner than they did the huge value locked up therein. Coca-Cola was a similar case. By
the standard rules, neither Coke nor Disney was cheap. Valued by their franchises, both
were steals.
Does this mean that "value" investing is dead? That you can no longer make money buying
stocks whose prices are cheap relative to earnings, book value or sales? Not necessarily.
It's no accident that Warren Buffett, disciple of Ben Graham and a student of value, was
among the first to recognize that franchises are assets as much as or even more than
things accountants can count. It's simply a question of extending the concept of value.
Of course such measurements can never be as accurate as a count of widgets piled up in
a warehouse. They get into all kinds of fuzzy things, and accountants hate fuzziness. Yet
the profession would be wise to remember what John Maynard Keynes once said: "I'd
rather be vaguely right than precisely wrong." |
