BlueSky Thinking Summary

In a recent study, Kellogg finance professors Robert Korajczyk and Ravi Jagannathan, along with post-doc Kai Wang, challenge conventional measures of profitability as used in corporate finance.

They argue that under current generally accepted accounting principles, intangible investments by firms, like R&D or advertising, are immediately expensed under GAAP and may be masking a more accurate assessment of firm profitability.

Their research puts forward a new metric using such intangible investments whereby firms that invest intensely in R&D and other similar initiatives are very strongly more profitable if such expenses are treated as long-term investments rather than immediate costs.

This measure of the attractiveness of profitability not only predicts better future operating profits and dividends but also outperforms traditional measures in the construction of profitable investment portfolios.

Their findings illustrate how, particularly in downturns, accounting practices review would present more investment-airtight plans, à la the Warren Buffett adage of revealing true business quality in times of turmoil.