On the concepts of earning, investment and expense

Earning is the most important concept in business. It is the most often used number to measure the value of a business. Like some other important concepts, the concept of earning does not accurately describe a company performance in every circumstance. We will take AOL as an example.

AOL distributed a lot of CDs as a marketing tool. Marketing costs are classified as expenses. With high expenses, AOL’s earning figures would look bad. So AOL argued that these CDs are really long term investments for they have long term impact on company performance. Since the marketing costs are classified as investments instead of expenses, AOL’s earning numbers looked great. Did this trick work? It worked long enough to maintain a high stock price to merge with Time Warner. The merged company was called AOL Time Warner because AOL had much higher market value than Time Warner. But soon after the merger, the actual earning from AOL part of the merged company was so small that AOL Time Warner was renamed Time Warner again.

What is the problem with the concept of earning? Financial reports are filed annually. Those expenses, such as machinery, that can be used for longer than a year are classified as investments. These expenses don’t appear as costs when they occur. Instead, the total costs are distributed over many years as depreciation. As a result, the time value of the investment costs is reduced. NPV calculated from earning numbers are higher than the actual NPV. Many investors are aware of this. They prefer to use cash flows, which capture the investment costs, instead of earnings to value companies. However, the calculation of cash flows requires more data and is more complex. For this and other reasons, it is the earning figures that are published in public media. They have very significant influence on the public perception of the company performance and company valuation.

How can we resolve this problem? Currently, there doesn’t seem to be a clean solution. Some investors, such as Warren Buffet, avoid companies that require frequent large investments. It will be helpful we are aware that earning number does not capture full picture of company performance.

There are many parallel examples in our daily life. Is piano lesson an investment or an expense? If a kid develops a life long interest in playing music, piano lesson is certainly an investment.  If a kid develops a life long hatred in playing music, piano lesson is probably an expense.  One needs more detailed understanding to make a judgment. More generally, is education an investment or an expense? Basic education, when applied to certain percentage of people, is a good investment. But too much education applied to too many people becomes more expense instead of investment. In university classrooms, how many students are browsing internet on their cell phones. They are much better off working instead of sitting idly in the classrooms.