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Finding hidden value

Many classic ratios used to identify value and quality are looking outdated. What is the value investor to do?
Finding hidden value

How can shares in the exact same company at the exact same price have a price/earning ratio (PE) of 19 based on one common accounting treatment but 39 based on another? The answer lies in how an increasingly pervasive accounting issue distorts companies’ income statements and balance sheets.

This issue is what recently caused highly respected fund manager and Fundsmith founder Terry Smith to brand PE ratios “a mockery” when used to compare valuations between different types of company. It's also why one leading accountant has labelled key accounting standards an "absurdity".

Meanwhile, adapting a value investment approach to circumvent the problem explains how a little-known, value-focused ETF provider has been able to consistently outperform the S&P 500 since launch, including during the recent collapse of value indices. 

Few inventors that grasp the issue are likely to use classic earnings- and balance-sheet-based ratios in the same way again, such as PE, price/book value (P/BV) and return on capital employed (ROCE). 

This piece will explain the problem and use a simplified example to illustrate the distortions it creates. We’ll also explore the growing real-world evidence of the impact on traditional value investing strategies.

Fortunately, being wise to the problem will go a long way to help investors amend their techniques. We’ll look at how this can be done and the ratios some professional investors have focused on to exploit the edge still offered by value investing; an edge based on deep-rooted human psychology. We’ll also see how the problem could potentially be fixed with some relatively simple changes to accounting standards.

Despite the much-purported demise of value investing, there are grounds to think the principle never stopped working, even if the traditional tools have got out of date. 

It’s time to start reinventing value.



The problem

The problem of interpreting company accounts with traditional valuation ratios has grown as intangible investment has become more important for companies over several decades. The significance of intangibles overtook that of tangible investments during the 1990s and the gap has continued to widen since (see Chart 1). 



Intangible investments include research and development (R&D), software, brand, know-how, staff training, artificial intelligence (AI), data, and certain types of sales expenditure if it locks customers into long-term relationships. These are some of the biggest creators of value for modern businesses. That makes the way this type of investment is treated by accounts particularly odd.

Accounting standards dictate that a company’s internally-generated intangible investments are usually treated as day-to-day costs (see 'intangibles' box). This means reported profits are reduced by the amount invested. It also means nothing is recorded on the balance sheet to reflect the long-term benefits created by the spending. And aside from R&D, details of what is spent is hidden from investors by being intermingled with costs related to the daily functioning of the business, such as electricity bills.

There is a very different and more informative accounting treatment applied to investments that are classed as tangible, such as buildings, vehicles and machinery. This spending is not treated as a day-to-day cost. Instead, tangible investments are 'capitalised'. That means the spending creates an asset on the company’s balance sheet. The balance sheet value of the tangible asset is then reduced through its useful life. These reductions in the asset’s value are reflected on the income statement as a 'depreciation' charge. Depreciation reduces reported profit each year until the entire amount that was originally spent has been put through the income statement. 

The sensible idea behind this treatment of tangibles is that the depreciation charge matches the cost of the investment with the benefit it produces. The better a company matches costs to revenue, the better and more informative is its reported earnings number. Unlike intangibles, investors also get information on the balance sheet and in the notes about amounts historically invested in tangibles along with the cost of maintaining assets. This record is important to help investors assess how successful a company’s capital allocation has been.

“It has started to become quite obvious that book value [reported net assets] is missing a significant chunk of value,” says Vitali Kalesnik, head of research for Europe at Research Affiliates. “Book value is almost a 19th century accounting measure of bricks-and-mortar investment, whereas in the 21st century a lot of investment is into intangibles...the big problem is there isn’t symmetry in how the intangible and fixed capital investment are treated.”

What really matters for companies and investors is not how accountants choose to categorise spending, but the future cash flows that the spending generates. It is the present value of all future cash flows that determines the value of an investment. The asymmetric accounting treatments for investment can make it very hard to determine what value to put on a business when using its income statement and balance sheet.



Same company, different ratios

In the latest annual letter to Fundsmith Equity owners, reflecting on the high PE ratios attached to many tech stocks, which are heavy users of intangibles, Smith wrote: "for any given level of investment in assets, the profitability of a company building an intangible asset is likely to be depressed versus a company building or buying a tangible asset. I am wary of explanations for why we should accept high valuations, especially if they are based upon theories about accounting. But whilst Sir John Templeton did say that the four most dangerous words in investment are ‘This time it’s different’... (which is actually five words before anyone points this out) sometimes it really is different and if you miss such inflection points it is to the detriment of your net worth.”

A simplified example helps illustrate the issue. 

Let’s start with a question, though. Which of the two companies in Table 1 is a more attractive investment?


Share price = 1,000p
 Tang. ResultsIntang. Solutions
FCF yld2.6%2.6%
Profit Margin20%10%

Anyone would be extremely hard pressed to tell from the information provided, but we are actually looking at the exact same investment. 

To understand what is going on, let’s start by looking at the substance of why the two companies  - called Tangible Results plc and Intangible Solutions plc - are identical from an investment perspective. 

  • Both companies have 100m shares
  • Both start out with assets of £100m and no debt
  • Both companies generate £1 of sales from every £1 invested in the business
  • For every £1 of sales, the companies generate 30p of earnings before investment, interest, tax, depreciation and amortisation (crucially, that’s EBIITDA and not EBITDA)
  • The maintenance spending required each year to keep investments productive amounts to 10 per cent of their value
  • All leftover cash at the end of the year is returned to shareholders and (for simplicity’s sake) the companies do not pay tax 

We meet these companies as they embark on identical ten-year growth plans. The plans involve investing an extra 10 per cent of sales each year over and above maintenance investment. 

Given the characteristics of both companies stay exactly the same over the ten years as they execute their identical growth plans, it will come as little surprise the cash they generate for their owners - what matters for investors - is exactly the same over the period. This can be seen in Table 2.


Tangible Results plc & Intangible Solutions plcIdentical investment merits
Value of InvestmentsSalesEBIITDA (EBITDA before investment spending)Maint. inv.Grth Inv.Free cash flow (FCF)
Yr 0£100m£100m£30m£10m£10m£10m
Yr 1 £110m£110m£33m£11m£11m£11m
Yr 2£121m£121m£36m£12m£12m£12m
Yr 3£133m£133m£40m£13m£13m£13m
Yr 4£146m£146m£44m£15m£15m£15m
Yr 5£161m£161m£48m£16m£16m£16m
Yr 6£177m£177m£53m£18m£18m£18m
Yr 7£195m£195m£58m£19m£19m£19m
Yr 8£214m£214m£64m£21m£21m£21m
Yr 9£236m£236m£71m£24m£24m£24m
Yr 10£259m£259m£78m£26m£26m£26m


But here’s where the funny business starts. There is a cosmetic difference between the two companies. 

  • All of Tangible Results' investments are classed as tangible, which means spending is capitalised (recorded as assets) and then depreciated in future years at a rate of 10 per cent (matching maintenance cost)
  • For Intangible Solutions, aside from maintenance spending on the original £100m of tangible assets, all future investments are intangibles (R&D, brand, AI etc)  and treated as day-to-day costs

Table 3 shows how this affects some key numbers reported by Intangible Solutions over the 10 years of growth compared with Tangible Results.


Reported AssetsSalesSpending on intangiblesEBITDADepr.EarningsEPS
Yr 0£100m£100m£0£30m£10m£20m20p
Yr 1 £110m£110m£0£33m£11m£22m22p
Yr 2£121m£121m£0£36m£12m£24m24p
Yr 3£133m£133m£0£40m£13m£27m27p
Yr 4£146m£146m£0£44m£15m£29m29p
Yr 5£161m£161m£0£48m£16m£32m32p
Yr 6£177m£177m£0£53m£18m£35m35p
Yr 7£195m£195m£0£58m£19m£39m39p
Yr 8£214m£214m£0£64m£21m£43m43p
Yr 9£236m£236m£0£71m£24m£47m47p
Yr 10£259m£259m£0£78m£26m£52m52p
Reported AssetsSalesSpending on intangibles*EBITDADepr.EarningsEPS
Yr 0£100m£100m£10m£20m£10m£10m10p
Yr 1 £100m£110m£12m£21m£10m£11m11p
Yr 2£100m£121m£14m£22m£10m£12m12p
Yr 3£100m£133m£17m£23m£10m£13m13p
Yr 4£100m£146m£19m£25m£10m£15m15p
Yr 5£100m£161m£22m£26m£10m£16m16p
Yr 6£100m£177m£25m£28m£10m£18m18p
Yr 7£100m£195m£29m£29m£10m£19m19p
Yr 8£100m£214m£33m£31m£10m£21m21p
Yr 9£100m£236m£37m£34m£10m£24m24p
Yr 10£100m£259m£42m£36m£10m£26m26p

*Growth investment plus maintenance spending on accumulated intangible investments

With thanks to Steve Clapham at Behind the Balance Sheet for suggestions on how to simplify the example


The ratios we saw at the start relate to Tangible Results and Intangible Solutions at the end of the 10 years of growth with their shares priced 1,000p. 

Looking at the ratios, it seems crazy these actually represent the same investment: valuations are wildly different based on PE and P/BV while the quality of the two companies also looks very different based on Return on Assets (RoA) and profit margin. Because of the simplified nature of this example, RoA is also equivalent to ROCE and return on equity (RoE).

What's happened? And why do some less ubiquitous ratios, such as free cash flow yield (FCF yld) offer a clear comparison between the two companies?

Starting with the balance sheet, we can see that Tangible Results’ reported assets (the first column on the left of the table) have grown steadily in the period in line with its growth investment.

By contrast, Intangible Solutions has not had any of its growth investment capitalised, which has resulted in its diminutive balance sheet. The relatively low level of assets is why the return on assets (RoA) ratio - profit as a percentage of assets - is higher than for Tangible Results, despite reported profits being lower. This is also the reason the company looks more expensive relative to its balance sheet; the P/BV ratio is higher. 

Reported profits have suffered at Intangible Solutions because of taking all the costs of growth up front (this is shown in the third column from the left, which also includes the maintenance spending intangible investment). Tangible Results looks more profitable because all investment spending is matched to its future benefit through the depreciation charge. This is what causes Intangible Solutions’ PE to look so high and its profit margin so low. 

There is another issue. Something counterintuitive happens when Intangible Solutions reduces its growth investment; reported EPS growth will shoot up.  

We can understand this confusing outcome by extending our simplified example. We’ll continue to monitor our companies for another ten years as the businesses mature. As growth opportunities dry up, the companies incrementally whittle back growth investment to zero. 

Chart 2 shows the surprising outcome. While the slowdown is easy to spot from Tangible Results’ reported EPS, for Intangible Solutions reducing growth investment reduces day-to-day costs and causes reported earnings to jump. So, based on reported earnings, it looks like growth has picked up at the very time it has actually begun to slow. Intangible Solutions ends up looking like a very good growth play throughout much of the slowdown period.



This illustrates another important consideration. Executive rewards based on targets for earnings, profitability or cash generation (i.e. EPS, margin, ROCE, FCF) can act as a strong incentive for near-term under-investment. Because information about the level and nature of intangible investment is hidden, it is very hard for investors to monitor whether spending is being cut to hit targets. 

The fact that accounting rules suppress information on intangibles is also likely to contribute to make such investments more expensive and more difficult to finance. Despite intangibles being the engine of growth for modern economies, banks remain reticent about lending against them. 

As well as the differences between our two companies, we can see there are some constants that offer a hint we are actually looking at the same investment. The high level view provided by sales is consistent between Tangible Results and Intangible Solutions. 

Free cash flow (FCF) is also consistent between the two. FCF is not affected because it looks at the cash being generated and spent during a year without discriminating between whether spending is classified as tangible or intangible. Regardless of how accountants choose to classify investments, sales are still sales and cash is still cash. 


Value still has a pulse

At a time when value indices have substantially underperformed the wider market and many have called time on the investment approach, the performance record of a small, value-focused ETF provider, Distillate Capital, looks hard to explain. 

The Chicago-based firm launched its first ETF on the rather ominous date of Halloween 2018. A year and a half later came the cataclysmic “value” rout of 2020. But despite its value focus, the Distillate Fundamental Stability and Value ETF (US:DSTL) has consistently beaten its benchmark, the S&P 500. That record includes the March 2020 crash and the subsequent recovery during which the S&P 500 Value index chronically lagged the main index. 



Indeed, the biggest peak-to-trough fall ('maximum drawdown' in industry jargon) experienced by DSTL’s 100-stock, rule-based portfolio during the 2020 crash of 33 per cent was not only less than the 37 per cent endured by the S&P 500 Value index, but was also less than both the main index and the runaway S&P 500 Growth index.

The ETF’s record is not a long one, but the likely reason for the outperformance so far appears to be that the company’s founders reinvented the value process to circumvent issues created by intangibles accounting rules. The firm’s strapline is “Value Investing Redefined for a Capital-Light World”. 

Distillate’s co founder Thomas Cole, a value investor of 35-years experience, says his firm’s cash-centric “redefinition” of value (more on this later) was based on a common sense examination of the problem. “To make a long story short, what we found is that if you're willing to cast aside a lot of Wall Street convention," he says. "What the industry tells you is important, and what the companies tell you is important, and focus instead on things that are irrefutable, you can do a good job of getting to an apples to apples comparison of valuation. Value has really never stopped working in our world.”

A reflection of just how consequential Distillate’s redefinition of value is can be seen in the fact that the ETF’s largest sector exposure at 26 per cent is information technology, which compares with the sector’s 12 per cent weighting in the S&P 500 Value index. 

Distillate is not alone in thinking that value’s much purported demise may not be all that it first seems. 

Several academics and quant firms published research over the past few years assessing the impact of intangibles on the performance of a 'classic' value strategy. A classic approach forms the foundations of the value indices that most pundits (the author included) use to assess the health of the investment style. 

The truly confusing thing about value’s chronic underperformance, which has now lasted for nearly 14 years, is that the investment strategy did so well for so long prior to the credit crunch. What’s more, value’s success had always seemed to be rooted in deep-seated human psychology. Have investors somehow managed to move beyond the age-old wiring of the brain? As a species, we show few signs of having made a sudden evolutionary leap. 

There are three key psychological traits that value investing draws on, many of which feed into what Nobel-prize winning behavioural economist Daniel Kahneman sums up as “what you see is all there is”. This idea gets to the nub of why the attractions of “value” stocks have historically been overlooked. Even when signs of improvement start to become evident, it remains very hard for us to believe a recently-horrible performance record will move back in line with a better long-term record (“reverting to the mean” in industry jargon). Can the investment opportunities created by such deep-rooted and widely-documented behaviour really have died?

Research Affiliates thinks it has found life at the core of value investing - even based on a classic value approach during the recent epic spell of underperformance. The firm discovered this beating-heart by breaking down the performance of a traditional long-short strategy based on P/BV (buy the cheapest 30 per cent and sell the most expensive 30 per cent). The break down allowed it to adjust for the impact of a massive widening of the valuation gap between growth and value stocks over the last 14 years - the gap has gone from being extremely narrow to extremely wide. After doing this, Research Affiliates found that the engine that has powered value’s long-term success (they measured from 1963 to mid-2020) was still running. 

This engine is based on the churn of value and growth stocks: recovering value stocks re-rate and outperform until they stop being “cheap” and are no longer classed as value; struggling companies see their shares de-rate and become “cheap” to provide the strategy with fresh fuel. The performance benefit of this churn is tracked net of the benefit to growth stocks from their superior earnings performance.  

According to the research, the net benefit of churn has been significantly lower during value’s historic run of underperformance at 1.1 per cent a year compared with an average of 5.9 per cent in the preceding 44 years. Nevertheless, the findings suggest the engine has not stalled and remains “economically meaningful”. Value still matters.

But Research Affiliates also tested what would happen if all the historical spending on intangibles that had been classed as day-to-day costs were treated as assets. Remember, doing this makes intangible investment show up as higher book value. That makes heavy users of intangibles look cheaper based on P/BV. 

While the process of making this adjustment across the entire market is necessarily somewhat crude, the results were striking. The long-short strategy based on intangible-adjusted P/BV performed substantially better than the classic unadjusted strategy (see Chart 4). Unlike the experience of Distillate’s ETF, though, the improved strategy still underperformed in recent years, and during 2020’s value melt-down.



Similar results were found from adjusting for intangibles in a study by academics Baruch Lev and Anup Srivastava which looked at the same long-short strategy based on both P/BV and PE. In 34 of the 39 periods tested, Lev and Srivastava found the intangibles-adjusted value strategy outperformed the unadjusted version. Furthermore, there was an increase in the level of outperformance of the adjusted strategies from 1970 to 2018, the period covered by the study. This is in line with the growing importance of intangibles in the investment mix.

It’s not surprising the results from adjusting for intangibles were different. Lev and Srivastava found 40 to 60 per cent of stocks were reclassified from their value and growth buckets once adjustments for intangibles were made. In other words, it looks like value investors using a traditional toolkit have been systematically excluding many value-plays from their hunting ground. What’s more, given the increased importance of intangibles for businesses, classic valuation techniques may well be excluding those value plays that are actually the most likely to recover and re-rate.

This tallies with Research Affiliates’ study which found hidden intangibles have become an increasingly noticeable feature for stocks classified as 'growth' (see Chart 5).



There have been similar findings about the impact of intangibles on value investing from other recent studies, including papers from leading quant investment firms AQR and O'Shaughnessy Asset Management

It is important to point out, though, intangibles alone do not explain all of value's recent poor run - from the perverse effects of interest rates on companies that otherwise would have failed, to capital access and technological change - but the issue does appear to have been very influential.


Value 2.0

Interpreting the accounts of real companies tends to be very complicated. It is often hard to fathom what exactly is going on. That’s why this piece has used a very simplified example to illustrate the intangibles issue. In the real world it is much tougher to unpick the truth from the accounting confusion.

It has taken a period of chronic underperformance by value indices and many value funds for the distortions created by accounting standards to start attracting widespread investigation by researchers. However, the issue has been of growing relevance for many decades.

Lev has charted the declining influence of earnings over several decades by tracking the returns available from perfectly predicting earnings. Not only is there a clear and progressive trend in the declining relevance of earnings (see Chart 6), but it is particularly noticeable for companies that have high operating costs (also known as selling, administrative and general costs or SG&A) compared with reported assets. Operating cost is where intangible investment is most often hidden when reported as a day-to-day cost.



Understanding the problem helps reinforce why it is so important that investors use a range of valuation techniques to assess price.  

Craig Baker, global CIO at consultancy Willis Towers Watson, is responsible for selecting fund managers that adopt a range of styles to run best-ideas portfolios for Alliance Investment Trust (ATST). “When you're looking at pure bottom-up stock pickers running 20-stock portfolios, which is what we use in the Alliance trust portfolio, quite frankly, none of them ever thought one or two metrics on their own were particularly useful," he says. "So in many ways, for the kind of managers that we're looking at, I don't think it's any different than it's ever been.”

Ratios based on earnings and the balance sheet do still have their uses. And they can be used to draw valid comparisons between a share’s current rating and the historical range, assuming a company’s business model has stayed consistent. 

But what about circumventing the issues created by intangibles altogether? The techniques used by the likes of Research Affiliates and Lev and Srivastava to add intantibles back onto companies’ books are useful for broad-brush studies, but this becomes fiendishly complex when applied to individual companies. 

Still, Lev suggests investors simply add back R&D expenses to reported earnings along with one-third of operating costs (the cost line in which intangible investment is most often hidden). He is currently working on quantifying the effectiveness of this strategy with encouraging results.

As the simplified example used earlier demonstrates, not all fundamentals are affected by the accounting issue. 

At the top level, sales are unaffected. Using sales as a valuation yardstick can be very helpful when investors have a view on future levels of company profitability. However, in terms of finding an alternative to earnings, a company’s free cash flow (FCF) looks the go-to metric. As we’ve seen, it is unaffected by the accounting treatment of intangibles.


From sales to cash

There is no standard definition of FCF. The basic principle, though, is that it reflects the money a company has generated in a year after all necessary spending, including internal investment and tax. It’s cash that can be used for things like acquisitions, dividends and paying down debt. 

FCF yield (FCF as a percentage of either share price or enterprise value) is the measure of value that is at the heart of the valuation rules to select stocks used by Distillate’s ETFs, which includes a recently launched international fund. 

“Instead of taking our existing systems and further complicating them, what we decided to do is go back to first principles; the idea that any asset is worth the present value of the cash that it will generate in the future,” says Cole. “A lot of people try to take R&D and capitalise it in some way… I don't even know how to do that. But I know what cash is. And I know you spend cash. It's the lowest common denominator.”

Fundsmith also focuses on FCF yield to assess value.

But FCF is also often tricky to accurately measure and define. Companies often go through cycles of heavy spending associated with growth. This can distort the picture offered by FCF over any given period. Excellent companies with fantastic growth potential can experience negative FCF for years - even decades - as they invest heavily to exploit opportunities. In such situations, if growth investment is generating a return above the cost of capital, then negative cash flow is actually a sign that shareholder value is being created.

Last year, finance researcher and academic Michael Mauboussin highlighted so-called maintenance FCF as a useful measure to get around the problem. This FCF measure attempts to only take into account the investments made by a business to maintain its operations. It’s a similar approach to for assessing earnings that is espoused by lauded value investor Warren Buffer . 

The big problem with maintenance FCF is that distinguishing stay-in-business investment from spending on growth can be hugely vexing. Sometimes companies are good enough to split out their maintenance spending from growth spending. However, they usually only account for investments that are reported on the balance sheet whilst ignoring the intangibles that are hidden from view. 

Star fund manager Nick Train has an earthy take on the question of valuation which gets around all these problems. The one measure of value he really pays attention to is the prices paid by acquirers of similar businesses. Surely this is the ultimate test of what a company is worth; what someone is prepared to pay for the whole thing. 

It’s no surprise that no one ratio can offer a simple answer to the question of how investors should approach valuation. What’s more, even traditional P/BV remains a valuable tool for assessing certain types of companies that generate their profits from tangible assets, especially if there is a secondary market for them. Examples include property companies and house builders, along with some industrials, financials and asset-backed retailers. 

When it comes to the question of assessing quality, it is interesting that Fundsmith still puts emphasis on the income statement and balance sheet. Smith puts credence in ROCE as well as operating margins. The significance of looking at the measures in tandem is that when both ROCE and margins are high, it suggests something is going very right. That’s because, as we’ve seen earlier, the mechanics of treating intangibles as a cost means the boost ROCE gets from the under-reporting of assets goes hand in hand with depressed margins. 

Smith also focuses on free cash conversion and interest cover, which are not affected by the intangibles issue. 

Other investors that have been vocal about the impact of intangibles on accounts seek to avoid distorted sections of the balance sheet as much as possible when assessing quality. Distillate, for example, screens shares for quality before selecting them on valuation grounds. To do this it focuses on the consistency of cash flows along with the level of debt and valuation risk. 

OSAM, which like Distillate is a rules-based investor (if it fits the criteria it’s a 'buy'), uses quality measures that attempt to highlight aggressive accounting as well as taking into account debt.

The rise of intangibles has created major issues for the most ubiquitous valuation and quality measures used by investors as well as assessments of earnings growth. Investors need to take a commonsense approach to these tools in the knowledge that distortions exist. An expensive stock based on measures like PE or P/BV may be a value stock in disguise if it is a heavy user of intangibles. What’s more, when traditional indicators of quality, such as ROCE, look really great, this may tell investors that assets are hidden rather than that a company has a hugely efficient business model. And importantly, while FCF is a slippery beast, which is at the root of why it is not more widely used for valuation, it needs to be an important part of any assessment of value.

To borrow the conclusion of Mauboussin from his research into the subject: “The world changes over time. One of the most profound changes we have seen in the corporate world is in the form of investment. Current accounting standards do a poor job of reflecting the rise of intangible investment. A thoughtful investor’s best response is to make the adjustments necessary to see the world as it really is.”