Analysing ROIC (return on invested capital)

Analysing ROIC (return on invested capital)

Author: Joris Kersten MSc / Owner Kersten Corporate Finance

Kersten Corporate Finance: M&A advisory in The Netherlands + Business Valuations + Valuation training over the globe.

Source used: Morgan Stanley Investment Management: Counterpoint Global Insights/ Return on Invested Capital/ How to calculate ROIC and handle common issues. October 2022. M.J. Mauboussin, D. Callahan.

Introduction

A company creates value when the present value of the cash flows, from the investment, is higher than the cost of the investment.

This happens when the return of the investment is higher than the cost of capital of the investment.

To study this in a little more detail, we need to know how to calculate a measure called ROIC (return on invested capital).

ROIC (return on invested capital)

ROIC is calculated by dividing NOPAT (net operating profit after tax) by IC (invested capital).

Let’s first look at what NOPAT is, and means.

And then let’s look at what IC entails.

NOPAT

NOPAT is the numerator in the ROIC calculation.

It is the cash earnings a company has when it does not have debt or excess cash.

So NOPAT is the same whether a company is financed with debt or equity.

So removing the concept “capital structure” in NOPAT enables it to compare NOPAT across different companies.

NOPAT starts with earnings before interest and taxes (EBIT).

You then add amortisation from acquired intangible assets.

And you add the embedded interest component of the operating lease expense. And you do this because this is not an operating item, but a financing item.

At last you subtract cash taxes, and this includes the tax provision, deferred taxes and the tax shield.

So summarized: NOPAT = EBITA -/- cash taxes.

A little more detail on NOPAT: Amortisation

Maybe it is strange to add back amortisation but not depreciation.

But the reason is that depreciation is an operating expense.

And amortisation of acquired intangibles just reflects “accounting”.

When for example a company acquires a customer list, the list would be put on the balance sheet as an intangible asset and amortised over its useful life.

But the money spent to maintain and grow the list is an expense in the income statement.

So the company should not be panellised twice with both the expenses and amortization.

( more about intangible assets, and amortisation, later in this ROIC blog series, in upcoming weeks )

Embedded interest in lease

Adding back embedded interest from operating lease is a relatively new adjustment.

Most companies nowadays under US GAAP and IFRS must reflect operating lease on the balance sheet.

This was not the case in the old days.

( I am from The Netherlands, and under Dutch GAAP we still have operating lease not capitalised on the balance sheet )

Under US GAAP, the entire lease expense including embedded interest is still expensed.

And under IFRS the lease payments are allocated under depreciation and the interest expense.

So for companies under US GAAP you need to separate the lease payments into these two parts (deprecation & interest), and “embedded interest” needs to be adjusted in NOPAT.

Cash tax

The cash tax calculation has three components:

-Tax provision;

-Deferred taxes;

-Tax shield.

With the tax provision you start with what you see in the income statement.

But you need to adjust this number for “unusual items” like for example a restructuring charge.

And with companies that spend a lot on R&D, in the US this needs to be amortised, instead of being expensed straight away.

Then there are deferred taxes.

A company has 2 annual statements, one for tax purposes and one for financial reporting.

Typically straight line depreciation is used for financial reporting, and accelerated depreciation for tax purposes.

This creates timing differences, that results in a company’s reported tax that is higher than the cash taxes.

( with accelerated depreciation you have less profit = less tax )

Eventually this tax needs to be paid, and this is captured as a deferred tax liability (DTL) on the balance sheet.

The increase in the DTL reduces cash taxes.

( so take the DTL increase from the reported tax, in order to arrive at cash tax )

At last, the tax shield is removed from NOPAT, because NOPAT is not influenced by capital structure.

And the tax shield comes from interest deductible for corporate tax.

So this increases cash taxes for leveraged companies, in order to be able to compare them well with other companies.

Concerning taxes, the quick and dirty way to deal with it is by taking EBITA * ( 1 -/- cash tax rate ). And the cash tax rate is as a (very rough) rule of thumb 95% of reported tax.

Invested capital

IC ( invested capital ) is the denominator of ROIC, and this can be calculated in 2 ways.

You can look at net assets (operating approach), and you can look at how these assets are financed (financing approach).

IC – Operating approach

With this approach we start with net working capital; a measure of liquidity, and this is calculated as current assets minus NIBCL’s (non interest bearing current liabilities).

Within the current assets accounts receivables and inventories are the largest components.

But you need to subtract excess cash and marketable securities from the current assets, since this is not “operating”.

NIBCL’s are basically all current liabilities that are not debt, and the main components are accounts payables and other current liabilities.

Then we add PP&E (property, plant & equipment).

( Concerning intangible assets, I will discuss this issue in great detail in this blog sequence on ROIC in the upcoming weeks )

Leases longer than a year also are shown on the balance sheet, and stand for the right to use the asset.

Accountants quantify this by estimating the present value of future lease payments.

Next we add intangible assets and goodwill from M&A transactions.

At last, all other long term (operating) assets need to be taken up.

So invested capital should reflect all the assets needed for a company to run its operating business.

NON operating assets like access cash, marketable securities, equity investments, non consolidated securities, finance subsidiaries, overfunded pension funds, tax loss carry forwards etc., should be taken care of in the “equity bridge of valuation” and NOT in IC !

IC – Financing approach

Within this perspective we start with all the sorts of interest bearing debt.

Operating lease obligations also need to be taken into account.

And we need to add shareholders equity, preferred stock and other equity linked securities.

At last, other long term liabilities like deferred tax, underfunded pension funds, unearned revenue etc. should also be taken up.

When both NOPAT and IC is calculated, we can calculate ROIC.

In subsequent blogs, in upcoming weeks, I will explain why ROIC is so important and practical !

Stay tuned, best regards Joris

Source used: Morgan Stanley Investment Management: Counterpoint Global Insights/ Return on Invested Capital/ How to calculate ROIC and handle common issues. October 2022. M.J. Mauboussin, D. Callahan.