While profitability decreased after 2021, the stock price increased from $124.3 to $415.70 over the same period. How can the stock price rise while profitability declines?

As chapter 6 instructs, there are two main drivers of value added (residual income), RNOA and net operating assets (NOA):

ReOI_t = (RNOA_t – r_Firm) x NOA_t-1

RNOA is the return per dollar of NOA, but residual operating income (ReOI) is determined by the amount of NOA earning at that rate of return. Here are the NOA for Microsoft from 2019-2024 (in billions):

While RNOA was declining, NOA was increasing. The is partly due to the acquisition of Activision Blizzard in 2023 and the continuing investment in cloud computing and AI. With this growth in NOA, the residual operating income for 2019-2024 (in billions with a required return of 8%) is increasing:

RNOA and NOA are the two summary drivers of ReOI. These, in turn, are driven by their drivers. This is the fundamental analysis of chapter 7.

The chapter also points to deficiencies with other profitability measures, more traps. But a number of commentators have pushed back on the accounting profitability measures we adopt, ROE (levered) and RNOA (unlevered). Here are some misconceptions about accounting profitability measures with a reply:

• Earnings are overstated due to inflation.

No: An investor wishes to understand the effects of inflation on a firm and looks to earnings to observe that effect. Does the firm have a hedge against inflation? Some firms can raise selling prices easily with inflation, increasing earnings and providing inflation protection. Reducing earnings for inflation takes out that information, reporting value lost during inflation versus value preserved.

• As accounting does not adjust for inflation, profitability is overstated: Earnings that incorporate inflation (with higher nominal revenues) are compared to net assets that are not restated to for inflation. Earnings and assets have to be on the same (purchasing power) dollar basis.

No: This is a misconception. Assets are investments to gain revenues and earnings so the lower the price paid for the assets the higher the rate of return on that investment. For example: Inventory is purchased for 100 but currently would cost 120 with inflation; earnings of 20 are higher because of inflation, so the book rate of return is 20% rather than 0% with the inflation-adjusted inventory. The 20% gives recognition for buying inventory at 100 rather than 120, adding value. The firm has timed inventory purchases: Buy low, Sell high. The same applies to property, plant, and equipment: a lower investment cost means lower depreciation expense and higher profits with inflation.

There is a further point: Revaluing inventory or plant upwards for inflation and recognizing the corresponding gain in income would report that inflation adds value. But inflation typically damages firms and their stock prices. See chapter 8.

Yet another point: Accounting reports nominal profits and nominal book rates of return. In valuation, the earnings value added over book value (net assets) is charged with a nominal required return and that includes risk from unexpected inflation (see chapter 8 again): The value added is discounted for the risk to inflation.

• Accounting profitability measures do not put all investments on the balance sheet (R&D, for example). Thus book rates of return denominated in balance sheet assets are overstated.

No: Chapter 8 goes to lengths to explain why very risky investments are not booked to the balance sheet with the effect that the profitability measures convey risk to the investor. The operating principle is conservative accounting when faced with high risk, Good accounting for risk. (85% of R&D is unsuccessful, we are told.)

This adjusts EBIT for taxes, but at the statutory tax rate rather than the effective rate. And the denominator, while taking out cash and equivalents, leaves in other debt assets in short-term investments. More significantly, it does not incorporate operating liabilities.

In calculating their moat index, S&P Global calculate ROIC as

Total Debt is not net debt. It should be reduced by debt assets, and it should be by reduced operating liabilities. That then yields net financing debt which, added to total shareholders’ equity yields net operating assets. Net Income in the numerator includes net interest on debt and taxes on net interest. This is part of financing, not operations. Not good.

On average, ROA over the past 50 years is about 6.8% for U.S. firms. That on the face of it looks odd: With the average required return deemed to be about 10%, that means firms were typically earning less than their hurdle rate with this measure; the residual income from operations is negative. Indeed, the average ROA is not much higher than the average risk-free rate of 6.4% over these years. Investment in risky operations would seem to require a higher risk premium over the risk-free rate. In contrast, the average RNOA is about 11.2%.

Chapter 6 compared ROA and RNOA in fiscal 2022 for Microsoft. Here is the comparison for 2023 and 2024 with the difference explained by the amount of debt assets in total assets and the amount of operating liabilities (OL):

See Laplante, Skaife, Swenson, and Wangerin, Journal of Accounting and Public Policy 38 (2019), 89-105.

Source: Nissim, D. 2024. Earning Quality, Fundamental Analysis and Equity Valuation, Columbia Business School. At https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3794378.

Retail – (Growth in) same store sales; # of stores (total and periodic changes—opened, closed, relocated); selling/floor space; number of cars in the parking lots (e.g., Kang et al. 2021); GPS foot-traffic data (e.g., Jin et al. 2020, Noh et al. 2021); consumer search data from mobile devices (Froot et al. 2017).

Hotel – # of rooms; occupancy (in %), average daily room rate (ADR), and their product (revenue per available room); # of properties owned/operated/franchised.

Casinos – gaming tables; slot machines.

Pharma and biotech – # drugs and medical devices, product pipeline (products under development by phase and therapeutic; e.g., Lev 2017), patents and trademarks, sales force, market shares of main drags, years-to-patent expiration of main drags.

Hospitals – # of facilities/hospitals; # of beds; # of visits/admissions (total, inpatient, outpatient, and equivalent [= inpatient admissions times the ratio of total inpatient and outpatient revenue to inpatient revenue]); (growth in) same facility admissions (total, inpatient, outpatient, and equivalent); average length of stay; occupancies; procedures/surgeries

Airlines – (# of) revenue passengers; revenue passenger miles/kilometers, available seat miles/kilometers, and their ratio (passenger load factor); total revenue per available seat mile/kilometer (TRASM); cost per available seat mile (CASM)

REITS – Net asset value (with underlying assets often valued by applying asset-specific capitalization rates to the related net operating income); (growth in) same property/store net operating income; various measures of funds from operations.

Home builders – Information on backlog, periodic orders, and periodic deliveries—units, average price, and value; cancelation rates.

Social media/games – daily/monthly active users; monthly unique users

Telecommunication – access lines; minutes of use; service area population and population penetration (e.g., Amir and Lev 1996)

Technology – gross bookings; book-to-bill ratio (order received divided by units shipped and billed); traffic acquisition cost

Cloud, SaaS, and other subscription companies – Annual Recurring Revenue (ARR); net dollar retention

Auto – shipment data (units); average selling price

Mining – production (quantity) by metal; average price per unit by metal; cash cost (average cost per unit of metal produced); all-in sustaining costs (operating and sustaining capital costs per unit produced)

Oil and Gas – production per day (oil, gas, natural gas liquids); total production; realized price (average price received per unit); proved/probable/possible reserves, which are reserve quantities estimated with 90%/50%/10 confidence; exploration success rate; decline rates (the rate at which capacity; reserve replacement costs

Utilities – The main driver of demand at electric and gas utilities is ambient air temperature, with cold (warm) weather driving heating (cooling) demand in the winter (summer) (e.g., Grieser et al. 2021).

Finance (banks, insurance companies, and other financial institutions) – volume-rate analysis of net interest income (primarily for banks);107 assets under management; assets under custody; net flows; capital ratios (e.g., Tier 1 common capital ratio); non-performing loans/assets; risk-weighted assets; premiums written; embedded value; reserve development data (Nissim 2010)

• High ATO comes with low operating PM (Restaurants, Business services, Trucking, Food stores, General stores, Wholesale durable goods)
• Low ATO comes with high operating PM (Pipelines, Communications, Utilities, Oil and Gas, Railroads)
• High financing leverage (FLEV) comes with low operating liability leverage (OLLEV) (Pipelines, Communications, Utilities, Hotels)
• Lower levered profitability (ROCE) is largely due to lower RNOA, not lower leverage.

These relationships are just averages, not necessary for individual firms.

This complements the ATO-PM plots in chapter 7. The graph below is similar to the one in chapter 7 but with different industries indicated:

That is correct. But, with the ROE version there is a point to note:

For years after the first year ahead (year 1), ROE is strictly

which is not equal to Expected ROE_t. You might be familiar with this from a statistics course: The expectation of a product (multiplication) of two numbers is not the same as the product of their expectations.

This is just a technical point. We always forecast expected earnings and book value, as in the first residual earnings equation: What will be the book value in years ahead and what will be the earnings that the book value (assets -liabilities) will yield?

On January 30, 2025, Walgreens Boots Alliance, Inc, the drug store chain, traded at a high annual dividend yield of 8.7%. The next day, on declining prospects, it announced it was suspending the dividend. The stock priced dropped by 10.3%.

As a signal, the dividend is just one indicator and an imperfect one at that. Many firms with good prospects pay no dividends. Berkshire Hathaway pays no dividends, and Meta Platforms (Facebook), Alphabet (Google), and Alibaba began paying dividends only recently.