The awkward link between Buffett’s moats and ROIC – Part ll

Superb Companies

Financial statements are an aid to business thinking

We only want to invest in superb companies. But we won’t buy them unless we can buy them at extremely attractive prices.

This post focuses on how we can identify superb companies. We are looking for companies with a sustainable competitive advantage that allows the company to earn excess returns on capital for a long period of time.

We would like to be assisted in our search by companies’ financial statements. From the financials we can calculate ROE, ROA, Price to Book Value, Debt Equity ratio and a number of other ratios. They all have serious shortcomings. My posts on these ratios can be searched out in Tags on the home page.

Our focus in this post is the ROIC and it’s spread with WACC. Such an approach is followed by many in the investment industry. What they do is assess sustainable competitive advantage by measuring the magnitude of the positive spread between return on invested capital (ROIC) and the weighted average cost of capital (WACC), as well as how much the company can invest in that spread.

See for example a report titled Measuring the Moat – Assessing the Magnitude and Sustainability of Value Creation, CONSILIENT OBSERVER | October 15, 2024 by Michael J. Mauboussin and Dan Callahan, the Consilient Research duo at Counterpoint Global Insights of Morgan Stanley.

As I noted in my first post on this subject,  The awkward link between Buffett’s moats and ROIC – Part l, it seems there are companies with substantial moats that are creating sustainable long term shareholder value but not showing it in accounting-based calculations of ROIC to WACC spreads.

The example I used was Amazon.com Inc AMZN. As I showed, half the time in the last ten years Amazon has not even earned its cost of capital. At least, that is the case if you rely on traditional accounting.

But Morningstar says: “We assign a wide moat rating to Amazon based on network effects, cost advantages, intangible assets, and switching costs.” So, it seems that just relying on ROIC doesn’t get you there.

So, what gives?

As I wrote in my earlier post:

“In the last fifty years the world has changed. Traditional accounting has not kept up with the massive shift of companies to investing in intangible assets rather than in tangible assets.

In his new book titled The Corporate Life Cycle – Business, Investment, and Management Implications published in 2024, Professor Damodaran writes: “When accountants misclassify expenses…as they continue to do with R&D expenses, a capital expense if you follow first principles but one that is treated as an operating expense – the accounting earnings can be skewed significantly.” (Damodaran, 2024) p.132 (Emphasis added)

The most important consequences are that reported earnings are distorted and the book value of company equity is also distorted (because the investment in intangibles of lasting value are expensed rather than capitalized), both of which impact the calculation of ROIC.”

Exploring the issue further

In my previous post we looked only at Amazon. In this post I propose to refer to five tech companies and focus on one in particular. See Figure 1 below. In the interests of full disclosure, I own shares in all of them. Amazon is updated  from my earlier post to most recent fiscal year end 2025. For more on these companies see my post How I invest my money.

My idea in looking at five companies is to see if we can come up with a more general conclusion about the usefulness of ROIC to WACC spreads as an indicator of moats. My focus will be on the ROIC side of things. By the way, every company has its own WACC. For present purposes I will assume that a WACC of 10% is a useful rough estimate as a starting point. See my post How to identify companies that make lots of money for shareholders

All five companies have either narrow or wide moats according to Morningstar. In fact, all of them were assigned wide moats until a couple of months ago when Morningstar shortened the moat durations for two of them because of risks of negative impact of AI on software companies.

Four of the five companies have ROICs of close to 10%. So, in spite of the fact that they all have moats, their ROIC to Cost of Capital spreads are close to zero. These numbers are just a snapshot based on fiscal 2025 year ends just completed. Year to year numbers can vary substantially.

What does this mean?

Their ROIC to WACC spreads are not suggesting moats, even though Morningstar assigns them moats. How to explain this apparent contradiction?

Each of the companies is spending massively on R&D. According to Professor Damodaran referenced above, a lot of this R&D should be capitalized and shown on balance sheets. Some R&D is legitimately expensed on an annual basis. Some of it creates intangible assets with a limited live expectancy and should probably be capitalized and expensed as it depreciates. A significant part of it creates intangible assets of indefinitely lasting value and should simply be capitalized and assessed annually for impairment.

There is another distortion that relates to goodwill. Goodwill is an intangible asset. Warren Buffett has a concept he calls Economic Goodwill. It is essentially the fair value of a company’s intangible assets whether or not they are shown on the Balance Sheet.

If a company acquires a number of companies at prices well above the book value of tangible and other assets, this accounting goodwill can quite properly build up on the balance sheet and add to the book value of shareholders equity. An identical company that has built up the same intangible assets through internal investment in R&D will not show these intangible assets on the balance sheet.

I have written about this in earlier posts. These three may be useful for investors not familiar with the shift. The emergence of a new model of capitalism, Investment in intangibles has wreaked havoc on the meaning of multiples and Buffett’s concept of economic goodwill vs accounting goodwill

One good way of assessing this is to compare a company’s Book Value of Equity with its Market Capitalization.

Descartes Systems Group Inc as an example

Let’s do a deeper dive into one of the companies to see if we can make sense of all this.

Descartes Systems Group Inc shows a Market Cap/Book Value of Equity ratio of 5.6. This is sometimes called a Price-to-Book Value ratio. Market Cap is Market Capitalization.

In simple terms, if you bought the entire company, you would pay Market Cap for the common stock. The price you pay, Market Cap, is a whole lot more than the Book Value of Equity. Assuming the price is a reflection of fair value, the difference is made up of Warren Buffett’s economic goodwill, an intangible asset. See Figure 1 for the 5.6 times numbers. Market Cap might be thought of as the ‘Market Implied’ value of equity.

Now we know that ROIC is the return on the sum of company debt and company Book Value of Equity. If the true value of the equity is 5.6 time that shown on the balance sheet, it’s obvious the ROIC number will be massively distorted.

But there’s more to it than that. The Book Value of Equity for Descartes includes a very large amount of accounting goodwill. That’s because Descartes has been acquisitive over the years.

Let’s just take the latest fiscal year, 2025. Descartes spent 105.3M on R&D, much of which was really capital investment in intangibles, and then went on to spend 157.4M in investing activities. Together that is 263.7M which might be thought as spent on normal capex. In fact, out of the 157.4M, the sum of 151.62M was spent on an acquisition.

Descartes moat

Here’s what Morningstar says about Descartes’ moat: “We assign a narrow moat rating to Descartes, driven by high customer switching costs and a network effect that has historically enabled the company to generate returns on invested capital in excess of its cost of capital. We believe excess returns will more likely than not continue for the next 10 years. Given the unknowns surrounding the impact AI will have on many software companies, we think it is inappropriate to assign a “near certainty” level of confidence to the return profile. We note the company is acquisitive and therefore has a sizable goodwill balance that depresses ROICs.” (Emphasis Added)

The statement “sizable goodwill balance that depresses ROICs” is clear but confusing. Acquisitions at fair value resulting in substantial accounting goodwill on the balance sheet should show the real situation. So how can a company with an ROIC of 10.2% have a sustainable competitive advantage, i.e. a moat?

The answer is that Descartes has been engaged over the years in investing in intangibles of lasting value which have not appeared on the balance sheet. The size of these intangible assets is indicated by the fact that the stock trades for 5.5 times the book value of equity. That is, the Market Implied intangible assets not appearing on the balance sheet. This is in spite of the fact that the company has a lot of accumulated accounting goodwill on its balance sheet.

A company that spends a lot of R&D on intangibles of lasting value will have assets not shown on the balance sheet and ROIC will be artificially inflated. Such a company that is also acquisitive will show depressed ROIC because NOPAT will be reduced because the investments in intangibles of lasting value will be expensed and depress earnings and hence NOPAT.

This is confusing. But it is a confusion that investors will suffer if they simply rely on the ROIC to WACC spread to indicate a moat. Is there another way of coming at this to make it all easier to understand??

Looking at another indicator

I look at Cash from Operations /Market Cap Equity Yield which might be called, what I coin, Return on Market Cap (ROMC). It’s a bit like Return on Equity (ROE) except that instead of using Net Income or earnings, as in ROE, it uses Cash from Operations and instead of using Book Value of Equity, it uses Market Value of Equity i.e. Market Cap.

By the way, for ROIC the calculation is made using NOPAT. For ROMC I use Cash from Operations taken from the Statement of Cash Flows.

One is treating Market Cap as a Market Implied fair value of shareholders’ equity. One can use market prices to imply various things about stocks. For example, a recent report by Michael J. Mauboussin and Dan Callahan, Consilient Research at Counterpoint Global Insights of Morgan Stanley explains the support for a Market Implied Competitive Advantage Period in Discounted Cash Flow valuations.

In Figure 1, I have calculated a ROMC to compare with ROE and ROIC. The ROMC is a number that make simple intuitive sense. If you were to buy Descartes at market prices, that is the cash return you would get on your investment. It makes sense in that it attempts to use market prices to put a market value on shareholders equity, shrouded as it is in an intangible fog.

It might help to answer the question whether the company is making a high return on its shareholders’ investment. It might even give a clue as to whether the company is in a position to earn excess returns on capital for a long period of time and reinvest in the business at high rates of return.

The ROMC number produced by Descartes is 2.96%. But, does this really help us?

Shortcoming of ROMC

The main problem with using ROMC is that Cash from Operations on the Statement of Cash Flows is very substantially reduced by the company’s investment in R&D. If the capex component of R&D was capitalized, the Cash from Operations number would be much higher and ROMC would be higher. Instead of 2.96% we would get 4.12%.

My flirtation with ROMC was intended to come up with a measure that makes sense in the same way that the expression ‘cash on the barrel’ makes sense. Its the money the company has available from operations to fund investment. Unfortunately, we still have to read and understand the financial statements and perhaps make adjustments.

Is there a simple solution?

It seems there is no simple way out of this. It would be nice if ROIC to WACC was a simple quantitative guide. No such luck. To answer the question whether a company has a sustainable competitive advantage that allows the company to earn excess returns on capital for a long period of time, the formula doesn’t take us too far. Lots of adjustments are necessary and then a qualitative business analysis is needed.

All five companies

The same analysis could be carried out with the other tech firms on Figure 1. I have done this and reach the same conclusion about ROIC and WACC spreads. I leave it to readers to reflect on this with the numbers in Figure 1.

Conclusion

The message here is that blind application of numbers from financial statements to any kind of formula is a mistake. None of the numbers produced for ROIC, ROE and ROMC make any sense without thought about what produced them. In investing you have to do your homework.

Figure 1

Company	Cash from Operations   >Market Cap/Book Value of Equity   Ratio Market Cap to BVE –   (higher ratio suggests Buffett Economic Goodwill – can also reflect overpriced stock or depressed price)	>>Latest fiscal year Investments -Capitalized on Balance sheet   <<R&D Expensed on Income Statement –   (Some creates lasting value like capital assets   R&D reduces Net Income, Cash from Operations and also NOPAT)	Cash from Operations /Market Cap Equity – Return or Yield (ROMC)   (solves problem of intangibles of lasting value not on balance sheet, but not expensed R&D reducing cash from ops)	Return on Equity Defined as Net Income return or yield on Book Value of Equity   (Missing intangible assets not on balance sheet)	Return on Invested Capital (ROIC) – uses NOPAT rather than Net Income/ Morningstar moat rating   (NOPAT needs adjusting up for R&D invest of lasting value- Also Invested Capital needs to be adjusted up for intangible assets not on balance sheet)
DSG  TSX/CA Descartes Systems Group Inc	266.2M   >9.0B/1,618.9M   Ratio 5.6	>>(157.4M)   <<R&D (105.3M)	2.96%   After expensed R&D	10.92%	10.92%/Narrow   Was Wide
AMZN NASDAQ/US Amazon.com Inc	139,514M   >2.7T/411,065M   Ratio 6.6	>>(142,545M)   <<R&D (108,521M)	5.17%   After expensed R&D	22.29%	15.49%/Wide
SHOP  TSX/CA Shopify Inc	1,468M   >234.1B/13,473M   Ratio 17.4	>>(1,190M)   <<R&D (1,523M)	0.9%   After expensed R&D	9.84%	7.29%/Narrow   Was wide
VEEV  NYSE/US Veeva Systems Inc	1,415.2M   >27.4B/7,214.8M   Ratio 3.8	>>(1,104.4M)   <<R&D (767.4M)	5.02%   After expensed R&D	13.63%	10.42%/Wide
CRM  NYSE/US Salesforce Inc	14,996M   >168.1B/59,142M   Ratio 2.84	>>(8,590M)   <<R&D (5,993M)	8.68%  After expensed R&D	10.26%	8.56%/Wide

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