Forecasting Corporate Financial Performance from Utilization of Capital Expenditure, R&D, Goodwill and Intangible Assets

This paper investigates the ability to forecast corporate earnings based on levels of capital expenditures, research and development, deployment of intangible assets and the actual and implicit value of existing goodwill. We find that correlation and lead/lag time series analysis does not accurate convey expected profitability generally measured by either internal rate of return measurement or a discounted present value approach.Regression of all four criteria measured in aggregate provides inferences that are not generally consistent with the interpretations of extant regressions that include expenditure and asset balances as independent variables. We find that coefficients of variables that have been viewed as proxies for assets that can be redeployed, such as R&D, Capital Expenditures, and Intangible Assets, have different effects in financial fundamental regression than in market value based regression of company performance returns. In addition, higher levels of Capital Expenditure and R&D made during the growth stage of the economic cycle generally do not come to fruition until after the cycle has peaked. Therefore for many corporations, the less sanguine view of current and future earnings prospects during lean economic periods understates the impact of capital projects and research. Moreover, when considered along with the prevalent view of lag time for obtaining fair-value information pertaining to intangible assets and existing goodwill, potential exists for underestimating corporate earnings by as much as 7% after adjusting for asymmetric information surrounding earnings announcements. Viewed over a longer term horizon of a year or more, goodwill and intangible asset growth over a period of several years results in statistically significant excess returns within two years of occurrence. The spike in intangible asset values due to M&A activity results in short-term stock price levels of resistance. This is to be expected when absorbing the costs of deals and the post merger integration issues. However, we find that technology focused companies and large multinational corporations continue to outperform relative to the overall market well after M&A integration is accomplished and costs fully absorbed.Conversely, earnings announcements which “miss” estimates coincide with announcement of revisions pertaining to accounting methodology pertaining to asset impairment and/or capital investment sunk and unrecoverable expenditure. When adjusted for the appropriate multiple over earnings or cash flow for the particular industry or segment, the potential impact of accounting charges against income due in large measure to intangible asset impairment can be measured against the assets earnings potential. Based on our sample, the potential for lower earnings existed for 38% of the S&P 1500 firms studied resulting in the likelihood that earnings may be overstated by as much as 5%. Moreover, lower levels of Capital Expenditure and R&D financing do not provide material insight into the potential for earnings fallout absent the phenomena of earnings management. Strategic initiatives surrounding cash flow financing and tax-related transactions are a better means to glean situations that may result in diminished earnings forecasts and actual results. This approach would be aligned with reference class forecast methods and would help alleviate any cognitive biases and the impulse to tap into a rainy day reserve to meet financial performance objectives.