Imagine you're considering buying a small, high-quality vending machine for your office lobby. The machine costs $10,000. You do some research and figure that, after paying for the snacks and drinks to stock it, you'll make an average profit of $2,000 per year. A very quick, back-of-the-napkin way to see if this is a good idea would be to say: “I'm making $2,000 per year on a $10,000 investment. That's a 20% return, right?” In essence, you've just calculated the Accounting Rate of Return. ARR is one of the simplest methods used in business to gauge the potential profitability of a capital expenditure—a big purchase like our vending machine, a new factory, or a major software upgrade. It answers the question: “Based on our accounting books, what percentage return will we get each year, on average, from this investment?” It's called the Accounting Rate of Return for a crucial reason: it doesn't look at the actual cash flowing in and out of your bank account. Instead, it looks at the net income or profit as reported on the income statement. This figure includes non-cash expenses, most notably depreciation—the accounting concept of an asset “wearing out” over time. So, while our vending machine might be spitting out crisp dollar bills (real cash), the ARR calculation first subtracts a “paper” expense for the machine's declining value before telling you how profitable it is. This distinction between accounting profit and actual cash is a fault line that separates simplistic analysis from the robust approach of a true value investor.
“Cash is a fact, profit is an opinion.” - A popular accounting maxim that every value investor should tattoo on their brain.
For a disciplined value investor, the Accounting Rate of Return is a tool to be viewed with extreme skepticism. While other analysts might see it as a useful shortcut, a follower of Benjamin Graham or Warren Buffett would immediately recognize its fundamental, almost fatal, flaws. Here’s why ARR clashes with the core principles of value investing: 1. It Violates the First Commandment of Finance: The Time Value of Money. The single most important concept in finance is that a dollar today is worth more than a dollar tomorrow. This is because a dollar today can be invested to earn a return, making it grow. Value investing, particularly through methods like discounted cash flow (DCF) analysis, is built entirely on this principle. ARR completely ignores it. It treats a dollar of profit earned in Year 1 as having the exact same value as a dollar of profit earned in Year 5. This is a critical error. A project that generates its returns quickly is far less risky and more valuable than one that generates the same total returns over a much longer period. By averaging profits and ignoring timing, ARR can make a terrible, slow-paying project look just as good as a fantastic, fast-paying one. 2. It's Based on “Opinion” (Profit), Not “Fact” (Cash Flow). Warren Buffett has spent a lifetime focusing on businesses that gush cash. Cash flow is the lifeblood of a company; it's what's used to pay dividends, buy back stock, reinvest in growth, and pay down debt. Accounting profit, on the other hand, is an accountant's estimate of performance and is subject to numerous assumptions and manipulations. Management can change depreciation schedules, recognize revenue differently, or alter other assumptions to make accounting profits look better or worse. ARR is based on this malleable “profit” figure. A value investor always prefers to follow the cash. They want to know “how much cash did the business generate for its owners?” not “what profit did the accounting department report?” 3. It Ignores the Return of Capital. Value investing is predicated on the principle of safety first. The first goal is not to lose money. ARR focuses only on the return on capital, without a clear picture of when you get your initial investment back. A different, also simplistic, metric called the payback_period at least tries to answer this question. ARR gives no insight into the risk of recouping your initial outlay. 4. It Can Distract from the Real Goal: Assessing Intrinsic Value. The ultimate goal for a value investor is to estimate a company's intrinsic_value and buy it for a significant discount. Intrinsic value is the present value of all future cash flows a business will generate for its owners. Because ARR ignores the time value of money and focuses on accounting profits, it is utterly useless for calculating intrinsic value. Relying on it can lead an investor to focus on a simplistic, and often wrong, percentage, rather than doing the hard work of understanding the long-term cash-generating economics of the business. In short, a value investor sees ARR as a relic of a bygone era of financial analysis. It's a quick estimate that can be calculated from an annual report, but it lacks the intellectual rigor required for serious capital allocation. It answers a simple question in a simple way, but in the world of investing, simple answers are often the most expensive ones.
While we've established its significant flaws, it's still important to understand how ARR is calculated. You will encounter it, and knowing how it's constructed allows you to understand its weaknesses from the inside out.
The basic formula is straightforward: ARR = Average Annual Profit / Investment However, the devil is in the details, as both “Average Annual Profit” and “Investment” can be defined in different ways, which is one of the metric's weaknesses. Step 1: Calculate the Average Annual Profit This is the net income the project is expected to generate, after subtracting all costs, including the non-cash expense of depreciation.
Step 2: Determine the “Investment” Amount This is where things get inconsistent. There are two common methods:
The result of the ARR calculation is a percentage. In theory, a higher ARR is better. Most companies that use ARR establish a “hurdle rate.” This is a minimum acceptable rate of return that a project must exceed to be considered. For example, a company might decide it will only pursue projects with an ARR of 15% or more. From a value investor's perspective, this interpretation is fraught with peril:
Let's revisit our “Steady Brew Coffee Co.” example to see ARR in action and expose its flaws. Steady Brew is considering buying a new, state-of-the-art espresso machine to increase sales and efficiency.
Step 1: Calculate the Annual Depreciation Depreciation is the cost of the machine spread out over its useful life. We'll use the simple straight-line method.
Step 2: Calculate the Average Annual Accounting Profit This is the new revenue minus the new cash costs and the new non-cash depreciation charge.
Since the profit is the same each year, the average annual profit is also $8,000. Step 3: Calculate the ARR (using both methods) Method A: Using Initial Investment
Method B: Using Average Investment
The Analyst's vs. The Value Investor's View An analyst using ARR might report: “The project has an excellent ARR of 16%, and potentially as high as 32%, well above our 12% hurdle rate. We should proceed.” A value investor would immediately dig deeper and reframe the problem in terms of cash. The Value Investor's Cash Flow Analysis: “Let's ignore the accounting for a moment. How much real cash does this machine put in our pocket each year?”
“So, the real deal is this: we pay $50,000 today, and in return, we get $18,000 in cash for each of the next five years. The accounting profit of $8,000 is a distraction; it's artificially lowered by the $10,000 non-cash depreciation charge. The true cash-on-cash return is much higher.” The value investor would then use a DCF, NPV, or IRR calculation on that $18,000 annual cash flow stream to make a truly informed decision. The 16% ARR, based on a smaller profit number, significantly understates the project's cash-generating power in this case. In other scenarios with different cash flow patterns, it could just as easily overstate it. The key takeaway is that ARR is unreliable because it's not looking at the right thing: cash.
Every financial tool has its place, even a flawed one like ARR. A balanced perspective requires understanding both its (few) strengths and its (many) weaknesses.