This report is one of a series on the adjustments we make to convert GAAP data to economic earnings. This report focuses on an adjustment we make to convert the reported balance sheet assets into invested capital.

Reported assets don’t tell the whole story of the capital invested in a business. Accounting rules provide numerous loopholes that companies can exploit to hide balance sheet issues and obscure the true amount of capital invested in a business.

Converting GAAP data into economic earnings should be part of every investor’s diligence process. Performing detailed analysis of footnotes and the MD&A is part of fulfilling fiduciary responsibilities.

We’ve performed unrivaled due diligence on 5,500 10-Ks every year for the past decade.

Assets from discontinued operations are assets that are held for sale by a company. These discontinued operations assets are disclosed as a separate line item on the balance sheet. While invested capital usually includes all capital invested in a business over its lifetime, we remove these discontinued operations assets from invested capital for a more accurate picture of how much operating capital a business has on hand to generate NOPAT. We also remove the income or loss from discontinued operations, which we detail in a separate report.

Most investors would never know that these discontinued operations distort GAAP numbers by over-stating assets on balance sheets and distorting the picture of a company’s ability to generate a return on that capital.

Goldman Sachs (GS) classified its reinsurance business as held for sale in 2012, with assets of $16.9 billion. Along with a much smaller asset held for sale, GS had nearly $17.1 billion in assets held for sale in 2012, with no material income or loss resulting from these assets according to its financial statements. Without adjusting for these discontinued operations, investors would mistakenly expect GS to have invested capital of $97.2 billion and a return on invested capital of only 8.7%. Removing discontinued operations lowers GS’s invested capital to only $76.1 billion and its ROIC is 11.1%.

Figure 1 shows the five companies with the largest (gross value and as a % of net assets) discontinued operations capital adjusted out of invested capital for 2012.

Figure 1: Companies Most Affected By Discontinued Operations in Invested Capital in 2012 

DiscontinuedOperationsSources: New Constructs, LLC and company filings.

These companies are far from the only ones affected by discontinued operations in invested capital. In the last fiscal year, the removal of discontinued operations from invested capital occurred for 332 different companies for a total adjustment value of $100 billion. Our database contains over 3,281 instances of discontinued operations removed from invested capital for a total adjustment value of $933 billion.

Discontinued operations in invested capital can artificially depress return on invested capital and make a stock look undervalued. Case in point: OneBeacon Insurance from Figure 1. OneBeacon had a total of $2.2 billion in discontinued operations removed from invested capital. Without this $2.2 billion in discontinued operations removed from invested capital, OB would have recorded invested capital of $3.6 billion and a return on invested capital of just 2.5%. Instead, with this adjustment, OB has a total invested capital of $1.4 billion and an ROIC of 6.4%.

Without this adjustment, it would have appeared that OB was unable to generate any meaningful return on the capital invested into its business. With this adjustment however, OB looks to be in much healthier shape, and earns a 4-star, or Attractive rating. Diligence pays.

Sam McBride and André Rouillard contributed to this report

Disclosure: David Trainer, Sam McBride and André Rouillard receive no compensation to write about any specific stock, sector, or theme.

    2 replies to "Discontinued Operations Removed from Invested Capital – Invested Capital Adjustment"

    • Anonymous

      Hi Sam,

      I’m a new subscriber.

      I only know this in theory, but are you able to expand on this article by talking about how companies could possibly shift losses to discontinued operations i.e., management may increase its allocation of costs to the discontinued business. The potential impact is continuing operations would appear more profitable for the reporting period. Subsequently, operating expenses would revert to normal levels.

      Thank you.


    • Sam McBride

      Hi Jonathan,

      Thanks for reading and subscribing. This is a great question, and it’s absolutely true that companies sometimes engage in “earnings management” by classifying recurring expenses in discontinued operations. Researchers from Florida International University examined this hypothesis several years ago and found significant correlation between companies reporting large losses from discontinued operations and beating analyst expectations for recurring earnings:

      Unfortunately, there’s no real way to examine or correct for this behavior on an individual basis. There’s typically not enough disclosure to determine whether or not expenses have been correctly classified as part of discontinued operations for any particular company. The best way to avoid being burned by this sort of earnings management is to look at the longer-term trend in profitability and be suspicious of any company that routinely beats earnings expectations by 1 or 2 cents a share.


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