Key takeaways from Calculating Return on Invested Capital by
Michael Mauboussin and D.Callahan.
ROIC is a measure of a company's capital efficiency.
Value Creation includes the spread of what a company earns above the cost of capital and how much the company can invest
Buffett coined the $1 test
  • To test the success of a business, you should check if $1 invested in the company generate value more than one dollar in the market place eg. If a company invests $1000 into a factory and estimates the cost of capital at 10% . If the factory generates $80 in after tax earnings in perpetuity. The market value of the factory would be $800($80/0.10)and hence fail Buffett's $1 Test
We are interested in understanding the changes in ROIC over time, not just the present ROIC.
The goal of the investor is to find a mismatch between the expectations built into the stock price and the financial results the company will actually achieve.

The ROIC formula :

NOPAT
-measures the cash earnings of a company before financing costs
-assumes no financial leverage
-is the same whether a company is highly levered or debt free

NOPAT= EBIT - Cash Taxes

Invested Capital(IC)
-can think of it in 2 ways:
  1. Amount of net assets a company needs to run a business
  2. The amount of financing a company's creditors and shareholders need to supply to fund the net assets.


Let's look at Cisco as an example.
Cisco had a NOPAT of $10.4 billion and Invested Capital amounting to $30.4 billion.
Thus a ROIC=[$10.4billion/($33.6 billion+$27.2billion/2)]=34.1% in fiscal 2013


Practical Issues in Calculating ROIC
-hosts of issues require one to make adjustments when doing their calculation
  1. Excess Cash
  2. Goodwill
3.Restructuring Charges
4.Operating Leases
5.Minority interests
6.R&D capitalization
  1. Share Buybacks

Excess Cash
-treat ROIC and capital allocation issues separately
-the goal of ROIC is to understand how efficiently a company uses its operating capital, so we should only consider the cash a company needs to run its business
-so in calculations we need to exclude excess cash

Goodwill
-for a proper ROIC calculation, we need to make sure the numerator and denominator consistent.
-so we need to ;ay attention to companies that have been in M&A's
-if the company has been acquisitive, distinguish between operating returns and acquisition returns, thus we calculate ROIC including and excluding goodwill

Restructuring Charges
-restructuring charges include costs related to items such as reducing the size of the work force and plant closings
-you don't have to make any adjustments to capture the provision for charges

Operating Leases
-are any lease obligations the company has put on the balance sheet or capitalized
-if a company leases a substantial percentages of its assets, you should make adjustments for ROIC
-there are 2 steps to do this:
1.Adjust NOPAT by reclassifying the implied interest expense portion of the lease payments from an operating expense to a financing cost. This increases EBITA.
2.Add the implied principal amount of the lease to assets as well as the debt. This increases the invested capital

Minority interests
-adjustment for minority interests is relevant either:
  1. When another company owns a meaningful minority percentage of the company you are analyzing
  2. When the company you are analyzing owns a meaningful minority stake in another company
-in the first case: Calculate ROIC as if the business is wholly owned
-in the second case: Calculate ROIC as you would normally excluding the minority stake

Share Buybacks
-ROIC is not affected by share buybacks provided you strip out excess cash

Return on Incremental Invested Capital(ROIIC)
-it is not the absolute ROIC that matters, but rather the change in ROIC. Having a sense of where ROIC is going can be of great value. A useful measure is ROIIC.
-ROIIC recognizes that sunk costs are irrelevant and what matters is the relationship between incremental earnings and incremental investments.

Calculate ROIIC on a rolling 3 or 5 year basis. This is due to the fact that businesses sometimes have a volatile pattern of investments or NOPAT

This image below is of the ROIIC formula:


ROIC and Competitive Strategy Analysis
-companies with large excess returns generally have some competitive advantage
-an analysis of ROIC can indicate not only whether a company has a competitive advantage but it also shows what lies at the foundation of that advantage
-there are 2 sources of a competitive advantage:
1. Consumer Advantage - due to habitual use of a product and high switching costs
2.Production Advantage- allows the company to deliver its goods/ services more cheaply than its competitors

Lets breakdown ROIC:

NOPAT/ Sales = NOPAT margin

Sales/ Invested Capital= Invested capital Turnover

Low Cost Retailer
-low NOPAT margin
-higher invested capital turnover

Luxury Goods retailer
-higher NOPAT margin
-low invested capital turnover

If a company has a high ROIC through a high NOPAT margin- you should focus your analysis on a consumer advantage.

If high ROIC comes from a high turnover ratio- emphasize analysis of a production advantage



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