Thread by @borrowed_ideas

1/ Thread: Market-Expected Return on Investment (MEROI)

@mjmauboussin and Dan Callahan published their new piece today on MEROI. Regular followers know I'm a big fan of Mauboussin and a big believer of expectations investing approach.

Let's dig into the new piece.

2/ A company's valuation is just sum of two things:

Steady-State Value (SSV) + Present Value of Growth Opportunities (PVGO)

SSV = NOPAT capitalized by Cost of Capital

PVGO depends on three things...

3/
a. the spread between ROIC and Cost of Capital
b. how much a company can invest
c. how long a company can find value-creating opportunities

Calculating SSV is more straight forward, but PVGO is quite tricky and is riddled with many assumptions/forecasts.

4/ "Our task is to measure the PVGO accurately. You can do that only if you understand the difference between expenses and investments, which our current accounting rules obscure."

Before getting into investments/expenses dichotomy, let's understand the broader model first.

5/ Here's a simplified example how SSV and PVGO is calculated:

6/ What's MEROI?

It's the discount rate at which PV of incremental NOPAT inflows equals PV of investment outflows discounted at cost of capital.

If MEROI>Cost of capital, PVGO is positive.

P.S. Exhibit 1 and 4 are related; it's continuation of the same example.

7/ Let's get into the investments vs expenses dichotomy. Most of you probably heard the phrase "investing through the income statement" by now.

"Separating expenses from investments has never been so important."

More than one-third companies in Russell 3000 reports loss in P&L.

8/ It is of paramount importance to differentiate companies which are choosing to invest via R&D, SG&A with sound unit economics from the ones who are structurally unprofitable.

Optically, they may not appear much different in their P&L, so you need to peel through to see it.

9/ Mauboussin cites some academic paper which separated opex into 2 buckets:

a. Intangible investments (R&D, advertising)
b. SG&A i.e. anything that is left after excluding R&D and advertising. This is also termed as "Main SG&A"

Main SG&A is then further broken into 2 segments

10/
a. Discretionary investments to pursue growth opportunities

b. SG&A expenses that support current operations. This is termed as "Maintenance SG&A"

Intangible investments (as defined here) eclipsed maintenance SG&A in early 2000 and gained huge momentum post GFC.

11/ While you can conveniently ignore these bifurcations in many industries, you cannot do so in pharma, biotech, software, media industries.

Mauboussin walked us through an example: $MSFT. (Link in the final tweet of the thread)

12/ While these adjustments don't have any impact on FCF number (which is also why I prefer to look at FCF while valuing companies), ROIC based on reported numbers can be very volatile and misleading if you don't adjust P&L and Invested Capital accordingly.

13/ Other metrics such ROE has mostly lost its meaning because of buybacks. Even IRR can be misleading if there is interim cash flows.

End/ Link to the full piece: morganstanley.com/im/publication…

All my twitter threads: mbi-deepdives.com/twitter-thread…