Intangible Assets & ROIC Calculations
Valuation: Intangible assets & ROIC
Author: Joris Kersten MSc/ Owner Kersten Corporate Finance
Kersten Corporate Finance: M&A advisory + Business Valuation + Valuation Training
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
This is the 4th blog in this sequence on ROIC analysis (return on invested capital).
So in this sequence I have written three earlier articles, you can find them on the links below:
1.??????Analysing ROIC – Return On Invested Capital (June 15th 2023):
2.??????ROIC linked to business growth (June 16th 2023):
3.??????Practical issues with calculating ROIC (June 22nd 2023):
And in this 4th, and last, blog in this sequence I will talk about how to deal with intangible assets in the ROIC calculation.
Tangible versus intangible assets
Accountants record tangible investments on the balance sheet as assets.
And these assets are depreciated over their useful lives.
So these investments show up in the “invested capital” (IC) of a company.
And also depreciation is taken up in NOPAT.
On the other hand, accountants treat most intangible investments as expenses.
Take R&D as an example.
Accountants decided that companies should expense R&D because the benefits were uncertain.
And the link between R&D costs and sales was unclear.
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And this logic applied to R&D was extended to:
-Advertising;
-Employee training;
-Creation of software.
Capitalising intangible assets
The above creates a situation where (on average) companies that are “tangible asset intensive” have high NOPAT and high invested capital.
And companies that are “intangible asset intensive” have low NOPAT and low invested capital. These companies are called “asset light companies”.
But this does not enable us to compare company ROICs consistently !
So in order to do this you need to put the intangible assets on the balance sheet and amortise them over their useful lives.
And therefore you need to estimate the percentage of the various SG&A items (e.g. R&D, sales & marketing, general & administrative etc.) that should be considered an intangible investment.
This including their yearly amortisation !
By these adjustments, both NOPAT and invested capital, will be higher.
ROIC obviously is the ratio between the two.
And capitalising intangibles lowers ROIC for most profitable companies !
An important point to mention is that “free cash flow” will NOT change !
This because NOPAT and invested capital increase by the same amount.
So capitalising intangible investments does not change the value of the business.
But it does provide us with better insights into the company returns, and timing of the returns !
And it enables us to compare normal and asset light companies.
Thanks for reading,
See you next week again,
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.