In this previously published item, DataTrek’s Co-Founder Nicolas Colas examines just what constitutes capital and how it is measured.
— Telling jokes and funny stories is a hallowed ritual on Wall Street when waiting around for something big to happen. Since we’re all biding time until the latest round of US-China trade talks wrap up on Friday, we’ll honor the tradition today.
Back in the 1990s I worked at Credit Suisse as the US equity analyst covering the auto industry, and during that time our Director of Research Al Jackson decided we should all focus on return-on-capital analysis rather than just the usual earnings-per-share game. This was a new approach, but it was fine by me. The auto industry is nothing if not capital intensive and the DuPont model was the keystone of Alfred Sloan’s approach to managing General Motors back in the 1920s. I felt right at home in the new regime.
Other staffers, especially in sales, were less enthusiastic about this differentiated methodology so Al arranged for a teach-in to bring them up to speed. Attendance was mandatory, but as the old saying goes, “you can’t make them drink…” After the presentation:
- Al asked one of the salespeople, an affable fellow we’ll call Tom, “So what do you think of our new focus on return on capital?” Al, super bright and full of a convert’s zeal, wanted a thoughtful critique.
- Tom’s awkward response: “What is capital?” Having paid zero attention during the talk, he was not exactly up to speed.
- Al just stared back. A former amateur boxer, when you asked a dumb question he looked very much like a cobra about to strike. Things did not look good for Tom.
- But after a good 15 seconds, Al simply nodded wisely and said “Good question… We’ll need to do more work explaining that…”
And that is the subject of Story Time Thursday: “What is capital?” Three thoughts about this:
#1: The most important investment trend of the last 40 years is the decline of physical capital as a driver of corporate competitive advantage and stock market valuations. A simple example:
- In 1980 the Energy sector – maybe the most capital-intensive industry out there – was 29% of the S&P 500. Yes, that was a high water mark set by the 1979 oil spike. But Technology was 9% of the S&P 500 just as personal computers were starting to take off as a consumer appliance.
- Today, Energy is 4.5% of the S&P 500 and Technology is 22%. Add Google, Amazon and Facebook to that, you get 30%. Yes, “Tech” is right where Energy was in 1980.
- Another way to look at this: ExxonMobil’s PP&E last quarter was $252 billion, while Microsoft’s was $79 billion. Yet MSFT’s market cap of $1.1 trillion is +3x XOM’s $289 billion.
#2: GAAP balance sheet accounting understates intellectual capital and the long shadow that it casts on sustainable returns. A brief case study:
- Google’s GAAP total asset base minus cash was $135 billion last quarter. Over the last year it has earned $35 billion, which makes for a 26% return on its productive capital base.
- Could you really recreate Google for $135 billion and make a +20% return? Of course not. That number only reflects assets that are easy to measure, like servers, buildings and the narrow bookkeeping definition of intangible capital. The intellectual capital it took to build Google, maintain its lead today, and generate outsized returns is largely missing from the balance sheet.
#3: Since balance sheets are less meaningful, that makes cash flow and reinvestment rates/opportunities the real arbiter of “what is capital” and how investors value it. Another case study:
- Even income statements can be misleading. For example, last year, Amazon posted net income of $10 billion but had $31 billion of operating cash flow. The largest piece of the gap was depreciation ($15 billion), a physical capital concept, and well above the $1-2 billion likely necessary to replace worn out equipment.
- But since intellectual capital comes with its own price tag, we must consider AMZN’s $5 billion cash flow adjustment for stock-based compensation as a “real” cost. That still leaves Amazon with $25 billion of operating cash flow, which against a stated $162 billion balance sheet equates to 15% return on total capital.
- But… what will incremental government scrutiny do to those returns and where is AMZN’s next big opportunity? Intellectual capital may scale more easily than the bricks and mortar version, but the “moat” that it builds it still as vulnerable to regulatory involvement as Standard Oil was in 1911.
Summing up: there is no longer an easy answer to “what is capital?”, let alone how it should be assessed for the purpose of valuing a business. The old rule of “follow the money/cash flow” still holds, but now increasingly untethered from their ties to physical capital those are freer to roam.
