The Disadvantage of Technology Stocks

If you look at stock market valuations, you will notice that shares of technology companies are often more expensive than the market average. This higher valuation is often justified by several factors, such as their high growth potential and a more flexible business model that requires few tangible assets. For example, a company like Netflix can sell its service worldwide, whereas a company like Canadian National is limited by the location of its tangible assets.

Looking at Canadian National’s balance sheet, we see that 84% of its assets consist of property and equipment, such as railways and locomotives. In contrast, when we look at Netflix’s balance sheet, we find that property and equipment represent only 3% of its assets.

Companies holding real assets, like Canadian National, have an advantage that technology companies do not: the ability to depreciate a significant portion of their expenses. To illustrate this point, I will use a fictional example intended to make the explanation as simple as possible.

Imagine that CN must buy new locomotives costing $30M. When it makes the purchase, it withdraws $30M from its bank account. From an accounting perspective, this amount will not immediately appear in the company’s expenses because it uses the concept of capitalizing an asset and depreciating it in the future. To simplify my example, let’s assume the useful life of a locomotive is six years (although it is about 25 years). The accounting rule therefore allows it to record expenses of $5M per year for the next six years, up to a total of $30M.

In contrast, a company like Netflix, which invests $30 million in research and development to expand its advertising offering, cannot apply the same principle as CN; it cannot capitalize this expense. Like CN, it will withdraw $30 million from its bank account to pay the employees who developed the system. However, unlike CN, Netflix’s $30 million investment is considered an expense rather than an asset.

If Canadian National and Netflix both generate revenues of $100M this year, CN’s ability to capitalize more expenses and amortize them later will allow it to report much higher profits than Netflix.

Now imagine that the market capitalization of both companies is $1.0 billion. The price-to-earnings ratios of the two companies will then be very different: CN will show a ratio of 13.2 times earnings, while Netflix’s will be 17.9.

In conclusion, even though both companies have the same stock market price while generating the same revenues and expenses, accounting rules lead to very different price-to-earnings ratios.

To me, this difference seems illogical. Isn’t it reasonable to think that the investment in Netflix’s advertising platform will have a useful life of at least six years? Accounting standards allow Netflix to amortize the creation of its content over the years; so why shouldn’t it be entitled to the same advantage for the development of its technological solutions?

The impact of such a divergence is more significant for companies that spend a high proportion of their revenues on R&D. What are the solutions to address this problem?
The first solution is to adjust the accounting earnings of technology companies to reduce this disadvantage. This task is far from easy. First, it is difficult to estimate the useful life of an intangible asset. Should Netflix’s advertising system be amortized over 2 years or 10 years?

Second, details related to R&D expenses in financial statements are often obscure. In fact, among all expenses, there are probably research expenses that will lead nowhere and create no added value for the company. These should not be amortized. Moreover, for obvious competitive reasons, corporate executives do not want to disclose the exact nature of their R&D investments.

Third, it is necessary to adjust the balance sheet and the income statement to include past research and development expenses.

To implement this first solution, one must have a good knowledge of accounting as well as of the company and its ongoing projects.

Another, simpler alternative is to compare the two companies on an equivalent basis—free cash flow. This method seeks to examine what goes in and out of the company’s coffers. In the previous example, Netflix and CN record equivalent inflows of $100 and outflows of $30.
I am not trying to give a lecture on accounting. There are many exceptions, differences, and necessary adjustments, where each company must be approached differently depending on its own accounting standards (GAAP or IFRS).

My goal is to demonstrate that accounting earnings can sometimes be misleading. You may go astray if you look at a company’s price-to-earnings ratio without considering the details and expenses that lead to that result.

Jean-Philippe Legault, CFA
Portfolio Manager at COTE 100