Valuation: Issues with calculating ROIC
Valuation: Issues with calculating ROIC
Author: Joris Kersten MSc/ Owner Kersten Corporate Finance
Kersten Corporate Finance: M&A Advisory Netherlands (mid caps/ small caps) + Business Valuation (large caps/ mid caps/ small caps) + Valuation/ Financial Modelling training over the globe (New York, London, Middle East, Asia)
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 3rd blog on ROIC (return on invested capital).
In this sequence I have written two earlier articles, you can find them on the links below:
Analysing ROIC – Return On Invested Capital (June 15th 2023):
ROIC linked to business growth (June 16th 2023):
In this 3rd article I will talk about the practical issues with calculating ROIC.
Practical issues
When making ROIC calculations there are a few practical issues:
1.??????Excess cash & marketable securities;
2.??????Restructuring, write offs and litigation charges;
3.??????Minority interests;
4.??????Share buybacks.
Let’s now discuss these issues.
Excess cash & marketable securities (1)
Companies hold cash for their operations, they simply need some liquidity in order to do business.
Young businesses need a little more cash for this, because for them access to capital can be more difficult.
A (very rough) rule of thumb is to take 2% of revenue as cash needed for the operations, and then the rest is excess cash.
With a M&A deal the exact number of excess cash is calculated with the DD (due diligence), based on an average level of net operating working capital.
For less predictable companies with larger growth prospects, a ratio of cash to revenue up to 5% can be more suitable to use.
Restructuring (2 A)
Companies take restructuring charges when they plan to change the organisation of their business.
For example to cut costs by reducing the work force or by closing facilities.
And these charges mostly require a cost upfront.
Workforce reduction costs show up in the income statement, and this reduces NOPAT. And additional capital expenditures come up as a liability, affecting invested capital.
An asset write off reduces invested capital, and an additional capital expenditure increases invested capital.
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In this case, it would make sense to cut out the “accounting adjustments” for the restructuring, but to leave in the actual additional capital spending.
( so restructuring charges are seen as one offs, but be careful here, these charges need to be studied in detail first )
Further, most likely the restructuring comes along with cost savings, and these need to be taken up (when they make sense obviously) in future NOPAT calculations.
Write offs (2B)
A write off occurs when a company recognises that it overstated an asset’s useful life.
Reasons could be failing to consider 1) technological obsolescence and 2) inflation.
Depreciation is often used as a proxy for maintenance capital spending.
And gaps between real maintenance CAPEX and accounting depreciation is a predictor of future asset write offs.
For companies that write off assets regularly, adding it back to invested capital is suitable.
And when occurrence is rare, then you can let it go without an adjustment to invested capital.
Concerning goodwill and intangible impairment charges, it should be added back to invested capital.
This since management should be held accountable for past capital allocations in the form of M&A.
Litigation (2C)
Concerning litigation, companies add the estimated liability on the balance sheet.
This provision reduces equity, and comes back as debt, so invested capital is not changed (total of equity + debt).
NOPAT can be affected do by damage of reputation, and this is a matter of professional judgement.
Minority interests (3)
If a company owns part of the firm you are analysing, you can deal with ROIC as usual. There only might be a few tax implications.
At last, with DCF valuation, you minus this minority interest by another firm (in market value), from the enterprise value.
When the company you are analysing has a minority stake in another business, then you can also normally calculate ROIC, apart from some potential tax issues.
Although be careful, when the proceeds from the minority stake are not in NOPAT, then take out the minority interest from invested capital, otherwise the calculation goes wrong.
With DCF valuation, you add the (market value) of the minority stake on top of enterprise value.
Share buybacks (4)
When excess cash is used to buyback shares, buybacks have NO impact on ROIC.
This because then neither NOPAT or invested capital is affected.
Funding a buyback with debt also does not influence NOPAT, and invested capital.
Buybacks can influence "return on equity", but this only happens through changes in the capital structure (leverage).
At last,
One issue is still untouched: Intangible assets & ROIC.
How to deal with these intangible assets will be discussed in my next blog.
See you next week, thanks for reading, 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.