On not inventing a new ratio

If you like a good car crash, you must read Neomonic‘s post on the lessons he learned from a bum trade in Game, the video game retailer that seems poised on the edge of administration. He may have changed how I evaluate turnarounds.

Neomonic’s Game experience has convinced him to switch from comparing the value of equity to the value of total assets in judging whether a company is financially strong, to comparing tangible equity to total assets.

The difference is intangibles, most often goodwill, and, as Neomonic says, the value of goodwill is not reliable if, for example, the company needs to raise cash. Goodwill is the historical cost of acquiring businesses above the value of the physical assets acquired and if the company paid too much, and has subsequently failed to earn a satisfactory return from its investment, it’s unlikely to be able to sell it for much.

For turnarounds and deeply cyclical stocks, I made the decision to use tangible book value as my benchmark for value some time ago, for the same reason. You can’t really count on the intangibles.

It makes particular sense for turnarounds because they often over-invest in good times and then write off substantial chunks of that investment when things go sour. Counting the goodwill would be optimistic at best.

But I still use the ratio of total equity to total assets to gauge financial strength, which is incongruous, and equally optimistic.

And from that observation stems a third, embarrassingly obvious notion. That in judging the company’s earning power, I should use return on tangible equity.

The idea of ROTE was so new to me (though thinking about it, it’s a bit like Greenblatt’s definition of return on capital), I had to Google it just to check it exists. It does.

And it may explain why ‘bargain’ companies selling at prices below tangible book value look so bad in terms of earning power. One reason is of course they’re not earning much, but another reason could be that by using equity in the denominator of the profitability calculation we’re including all sorts of crud (a technical term for goodwill) that won’t actually contribute to future earnings.