• Generally Accepted Accounting Principles, or GAAP, while an important lens into corporate profitability, can often be distorted.
• In recent years several trends have had significant impacts on GAAP for some companies.
• In order to understand “true” profitability, investors should focus on the after tax cash flows companies generate.
“Profits are an opinion, cash is a fact.” – Alfred Rappaport
Last month we wrote about the potential trend in earnings for large capitalization companies in the US as we contemplate recession (It’s All About Earnings, August 16, 2022). While earnings trends will certainly impact equity returns, we were recently reminded that accounting and/or capital allocation decisions made by businesses can impact reported results but may lead to less than complete understanding of actual corporate performance.
For example, one of the most widely used measures of profitability is return on equity (ROE). Over the past several years, extremely low interest rates have led some companies to issue significant amounts of debt, used in part to buy back stock. Under GAAP accounting, a share repurchase leads to a decrease in both cash (asset) and shareholder’s equity on the balance sheet. This has led some companies to report negative shareholder’s equity in recent years, making the ROE calculation impossible, and therefore useless for comparison purposes.
Return on invested capital (ROIC), which measures after-tax cash flows as a percentage of total invested capital (working capital plus long term plant and equipment), creates a more comparable measure of corporate performance. The table below shows the 10 largest companies in the S&P 500 Index that reported negative shareholder’s equity in the past fiscal year.
| Name |
Ticker |
Market Cap |
Book Value per Share |
Net Share Repurchase Last 3 Years ($ millions) |
Share Repurchase as % of Market Cap |
Return on Invested Capital |
| MCDONALD'S CORP |
MCD |
174.40 |
-5.94 |
5,798 |
3% |
11.99 |
| ORACLE CORP |
ORCL |
168.26 |
-1.69 |
54,990 |
33% |
21.52 |
| PHILIP MORRIS INTERNATIONAL |
PM |
132.72 |
-6.51 |
775 |
1% |
39.98 |
| LOWE'S COS INC |
LOW |
123.95 |
-6.37 |
21,894 |
18% |
19.26 |
| STARBUCKS CORP |
SBUX |
101.73 |
-3.87 |
11,416 |
11% |
16.98 |
| ALTRIA GROUP INC |
MO |
80.86 |
-0.88 |
2,520 |
3% |
146.19 |
| BOEING CO |
BA |
77.48 |
-25.30 |
3,002 |
4% |
-1.85 |
| HCA HEALTHCARE INC |
HCA |
58.17 |
-2.94 |
9,687 |
17% |
13.05 |
| MCKESSON CORP |
MCK |
50.62 |
-13.32 |
5,815 |
11% |
35.01 |
| O'REILLY AUTOMOTIVE INC |
ORLY |
46.60 |
-0.14 |
5,789 |
12% |
25.13 |
| Average |
|
101.48 |
-6.70 |
12,168.60 |
11% |
32.73 |
| Median |
|
91.30 |
-4.90 |
5,806.50 |
11% |
20.39 |
Source: Credit Suisse, as of 10/12/2022
Most of these companies have been repurchasing a significant amount of shares in recent years, which has driven equity to negative levels. However, when we focus on after tax cash flows, most of these companies are in reality generating attractive ROIC.
Another example that investors may want to focus on is the trend in working capital (inventory plus receivables less payables). Since the financial crisis, as financing rates fell, US companies in aggregate have reduced working capital by approximately $500 billion (source: Credit Suisse) by using supply chain financing to push out payables. This had a positive impact on cash flows in recent years, but with increasing interest rates and supply chain issues, those gains may reverse to some extent. Some companies have already warned investors that working capital pressures could affect results negatively.
There are several additional accounting issues that investors will face going forward, such as GAAP vs. non-GAAP reporting, stock based compensation, foreign exchange translation and potential impairments of intangible assets, to name a few.
While GAAP accounting is important, investors are well served by focusing on after-tax cash flows in addition to reported earnings as Mr. Rappaport sagely advises.
Important Disclosures & Definitions
S&P 500 Index: widely regarded as the best single gauge of large-cap US equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization. One may not invest directly in an index.
Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.
ALPS Advisors, Inc. is affiliated with ALPS Portfolio Solutions Distributor, Inc.
ALPS Portfolio Solutions Distributor, Inc., FINRA Member.
AAI000198 12/31/2023
