[ Return on invested capital (ROIC) ]
Article contents –
- ROIC Intro
- Better than ROE
- An Example
- True Performance
- Declining ROIC
- Equity Isn't Free
- Cash's Role
> ROIC - Introduction <
Return on invested capital (ROIC) is a measure of financial performance and a financial performance forecasting tool that the Fool analysts have used for more than a year. We believe that looking at economic earnings -- free cash flow or return on invested capital minus a charge for the use of that capital -- produces a much better view of the economics and value of a company than just looking at earnings growth. After all, earnings growth comes at a price in many instances -- whether that's heavy investment in working capital, fixed assets, or the issuance of stock to acquire other businesses.
This series is an introduction to how ROIC is calculated. We believe it's as fundamental as learning how to calculate EPS or calculating a company's current ratio. It's not profit margins that determine a company's desirability, it's how much cash can be produced by each dollar of cash that is invested in a company by either its shareholders or lenders. Measuring the real cash-on-cash return is what ROIC seeks to accomplish. Keep in mind that this series initially ran in July of 1998. Therefore, the financial data in some examples is from that time period.
> ROIC - Better than ROE <
Return on invested capital is sort of like return on equity (ROE), but greatly improves upon it. Return on equity (net income divided by average shareholders' equity in use over the period being looked at) takes into account in the denominator only the net assets in use by the corporation. A major problem with this is that certain liabilities mandated by GAAP (Generally Accepted Accounting Principles) reduce the amount of resources at the company's disposal in the ROE equation. Depending on the circumstances, though, these liabilities should not be counted as a reduction in the capital working for the benefit of shareholders. They should be counted as an addition to capital in use by shareholders. That being the case, moving an amount out of liabilities and into owners' equity necessarily increases the denominator of the ROE equation and thus lowers the company's return on equity.
For example, insurance underwriter Cincinnati Financial (Nasdaq: CINF) owns large stakes in bank holding company Fifth/Third Bancorp (Nasdaq: FITB) and telecom services concern ALLTEL Corp. (NYSE: AT), both of which are being carried on its books at market value rather than at cost. Because banks and insurance companies have to mark their investments to market (value them on the balance sheet at market value), they also have to record a liability for taxes that would have to be paid if they were to liquidate the holdings. This liability is called a "deferred liability," because payment (or realization) of the liability is deferred until realization of the gain takes place. For CinFin, the difference between the cost and market value of these investments at year-end was $2.78 billion. That means there's a deferred tax liability on the books equal to its tax rate times the amount of this unrealized appreciation in investments.
Say CinFin has no intention of selling these investments within the next ten years? The deferred tax liability might exist in the mind of the company's creditors, insurance examiners, and accountants, but in the minds of the people running the company, the value of the liability is much less than the balance sheet states it to be. The company's operating managers can make investments and operating decisions based on a net value of these assets that is much larger than the balance sheet indicates. The amount of capital at the disposal of operating managers is much closer to the value of the assets on the balance sheet and not the value of the net assets (the investments minus the deferred tax liability) indicated by the balance sheet. They haven't put aside $1 billion to cover this liability, so investors must charge management with a larger amount of owners' equity in assessing the company's return on owners' equity for the period.
To reflect the difference and bring the amount of owners' equity closer to the actual amount of invested capital at the company's disposal, an investor or analyst would make changes to the following balance sheet:
Investments (in 000s):
Fixed maturities, at fair value...$2,751,219
Equity securities, at fair value...$5,999,271
Other invested assets...$46,560
Total assets...$9,493,425
=========
Deferred income taxes...$1,406,478
Total liabilities...$4,776,460
Total shareholders' equity...$4,716,965
Total liabilities and shareholders' equity...$9,493,425
========
We wouldn't make any adjustments to the asset accounts. Therefore, the sum of liabilities and owners' equity has to still match the amount of total assets. About 71% of the deferred tax liability is due to the appreciation of the Fifth/Third and Alltel stock, and these are by far the largest identifiable single equity positions the company has. So, we'll just treat these two in making adjustments.
We'll assume the company plans on holding these investments for another 10 years, and that the company can invest a sum of money in the S&P 500 and generate an 11% yearly return on that investment to cover the liability once it is realized. Based on the current gain that is on the balance sheet, it would need to set aside $382.4 million to cover the $1.086 billion liability for the unrealized appreciation of these investments on the balance sheet ($382 million invested at 11% per year for 10 years = $1.086 billion). That equals $704 million, which reduces deferred taxes and thus, total liabilities, by that amount, and is transferred to owners' equity. Therefore, the liabilities and owners' equity accounts look like this:
Deferred income taxes...$702,478
Total liabilities...4,072,460
Total shareholders' equity...5,420,965
Total liabilities and shareholders' equity...$9,493,425
========
Last year, Cincinnati Financial earned $299.38 million. On the first amount of owners' equity, the company would have generated a ROE of 6.35%. On the revised amount of owners' equity, the company's ROE was 5.5%. By making these adjustments, we can tell how the company is performing with the actual amount of investable assets under the control of its operating people. Insurance companies and banks make underwriting and lending decisions based on statutory limitations involving owners' equity, so these liabilities do indeed dictate the amount of business CinFin can do. But if we make these adjustments across a group of companies we're comparing as investors, we get a better idea of how well the company is operating.
In the next section we'll work into a full definition of ROIC and how that better refines some of these looser adjustments to just owners' equity In short, not all assets are funded by owners' equity, so looking at just owners' equity as a measure against which return is compared is going to miss the boat at times. Those companies that finance their assets with just a sliver of owners' equity and a boatload of liabilities can drive the value of owners' equity to zero pretty quickly with just one misstep. A 20% return on owners' equity in a company with very low leverage (defining leverage for these purposes as the ratio of assets to owners' equity) is a much different and preferable result to a company with very high leverage generating an ROE of 20%. We need an alternative definition of capital that measures the full amount of capital in use by a company's managers, whether that capital was raised through equity or through debt. In other words, we want to look at the company's performance independent of its financing decisions. ROIC is the way to do that.
> ROIC - An Example <
As we said in the first part of this series, return on invested capital is somewhat like return on equity (ROE), but it improves upon it. In the example we set forth, we modified the amount of shareholders' equity assumed to be in use by management because Generally Accepted Accounting Principles (GAAP) can understate the amount of resources that a company currently has at its disposal. That, in turn, can overstate the company's return on capital and lead to an investor misjudging the performance and economics of a business he or she is analyzing.
Return on invested capital leaves ROE in the dust for a number of reasons. First, ROE takes as the invested capital base just the residual of assets minus liabilities. An investor might think that a 15% return on equity is an acceptable return in all circumstances, but one has to look at the leverage and return on all capital before making the judgment that equity is safe.
Take this example using these average balance sheet amounts:
Total assets...$3,000
================
Accounts payable...$200
Accrued Compensation Expenses...$200
Current Portion of Long Term Debt...$100
Long Term Debt...$1,750
Total liabilities...$2,250
Shareholders' Equity...$750
====================
A company generating earnings of $112.50 during the fiscal year would run a nominally great return on equity of 15%. An investor might be very pleased with that performance. Another way of looking at it, though, compares earnings to all capital invested in the business, which is all long-term and short-term capital -- in other words, owners' equity and all financial debt.
There are two ways to add up the capital at work, according to the theoretical work of Bennett Stewart III in The Quest for Value: The EVA Management Guide (this work is also backed up by a heck of a lot of practical application on the part of Stewart and his partners at Stern Stewart & Co., so this isn't just propeller-head stuff). You can add up the capital in use by a firm by focusing primarily on the right-hand side of the balance sheet (where you find liabilities and owners' equity) or by looking primarily on the left-hand side of the balance sheet, which is where assets are found. Remember, assets minus liabilities equals owners' equity -- the bottom line on a balance sheet. Rearranging the equation, though, gets us to an expression of how all assets are funded on a balance sheet: assets = liabilities + owners' equity.
So, we can calculate invested capital as being equal to all financial capital. We can also look at it starting from the asset side. Start with all assets and deduct non-interest bearing current liabilities. In the above case, we deduct from total assets of $3,000 non-interesting bearing current liabilities of $400. The liabilities of accounts payable and accrued compensation expenses do not represent capital invested in the business by either equity or debt holders. While they are debt under the most stringent forms of looking at the balance sheet, they don't represent invested capital. As long as a company pays its vendors within standard or agreed upon terms, accounts payable are not interest-bearing liabilities. As for accrued compensation expenses, any company that doesn't pay by the day is going to operate with an average level of these liabilities all year long. The value of work that an employee renders is found in inventory, if the company is a traditional manufacturer. Since many people are paid on a bi-weekly schedule, the value that the employee renders in labor between paydays is accrued. It's pretty much an interest-free short-term loan of labor.
Either way of looking at it, we have $2,600 in invested capital. Now we have to adjust the return before dividing it into invested capital to calculate ROIC. The net income figure that is used in the calculation of return on equity is not directly analogous to the "return" in ROIC. That's because ROE is concerned with the return on equity after all other financing sources have been taken care of. Net income is net of interest expense as well as other expenses below the operating income line on the income statement. We want to measure the income the company generates before considering what capital costs. In this way, we are looking at the pure earnings power of a corporation before taking into account the decisions that were made to finance the business. Don't worry, we're not ignoring leverage here. We'll consider the cost of capital later in this series.
> ROIC - True Performance <
In the first two parts of this series, we looked at setting up the balance sheet to assess return on invested capital. We now look at the return part of the equation.
As pointed out in part two, we want to measure the income the company generates before considering what capital costs. In this way, we are looking at the pure earnings power of a corporation before taking into account the decisions that were made to finance the business. For the purposes of our example, here is the income statement we are working with:
Revenues...$1,875
Cost of Goods Sold...$1,200
Gross Profit...$675
Operating Expenses...$298.42
Operating Profit...$376.58
Net Interest Expense...$203.50
Pre-tax income...$173.08
Tax Expenses...$60.58
Net Income...$112.50
Compared to the adjustments that need to be made to the balance sheet, this is the easy part. The return the company is generating from operations is fully taxed operating income. To calculate this, we tax the company's operating income at a standard, statutory rate. In the
The tax component is something that no business can escape fully, although it can shield its operating profits with debt. We want to look at the earnings power of the company and not the efficiency of its tax planning. In assigning a standard tax rate across enterprises, we can judge the operating efficiency of capital without biases on the industry in which the capital is employed. Whether or not we tax operating income, the comparisons across industries will be consistent. The goal is to look at fully taxed operating income. So, in this example, operating income is $376.58 and fully taxed operating income is equal to 65% of that [1 - tax rate], which is $244.78. On a base of $2,600 in invested capital, the company's ROIC is then $244.78 divided by $2,600, or 9.4%.
In short, the formula for ROIC is:
After-tax operating earnings divided by [total assets minus non-interest-bearing current liabilities]
There are other ways to look at ROIC, though. Some people would modify the denominator in the above equation by deducting goodwill from total assets and non interest-bearing current liabilities. This is because goodwill is an intangible asset arising from the purchase of another company at a price higher than the acquired company's appraised net asset value. (Appraised net asset value is usually in the neighborhood of book value). The company's operating managers don't have use of this asset, so a company with goodwill is going to look less productive on an operating basis than a company without goodwill. Therefore, when we want to look at a company's operating ROIC, we back goodwill out of the ROIC equation, as intangible assets are financial capital, not operating capital.
On the same topic, we always want to back amortization of goodwill out of operating expenses. Since goodwill amortization (amortize literally means "to bring towards death") schedules can differ so much between companies and since this is a non-cash expense that is based on an accounting choice that is arbitrary (inside of statutorily permissible periods not exceeding 40 years), we don't count this is an operating expense. Again, this allows an investor to look at a company's operating performance before taking into account distortions to the cash return a company is generating.
In fact, cash-on-cash returns are what we're looking for in calculating ROIC. We're trying to look past distortions to return on capital that are borne of accounting conventions. Accounting is a rules-based system that allows for a number of choices that can be made by financial managers and approved by auditing firms that nonetheless distort the true economic earnings of a company. Cendant (NYSE: CD), for instance, was able to select a number of accounting policies that increased reported earnings, but analysts focusing on the company's return on invested capital rather than just earnings growth would have had a more useful metric for judging the company's economic profitability. That's because those expenses that were capitalized rather than run immediately through the income statement would have shown up in the ROIC ratio as a larger amount of capital rather than a smaller amount of after-tax operating income. Either way, an analyst can pay less attention to the accounting choices made to increase reported earnings and pay better attention to the company's cash-on-cash returns.
> ROIC - Declining ROIC <
In part 3 of this series on ROIC, we discussed how investors can look through reported earnings performance to get at true economic performance. Let's recap this discussion again before we move on, just to make sure everyone is on board the ol' Return on Invested Capital Bus. Bennett Stewart's basic thesis in The Quest for Value: The EVA Management Guide is that return on invested capital allows an investor to see the cash-on-cash return of a business. The cash-on-cash return is literally the amount of cash you get back compared with the amount of cash you had to invest in the business -- thus, the phrase "return on invested capital," or ROIC for short.
After removing all of the distortions created by GAAP accounting, looking at return on invested capital allows you to accurately measure how much cash you get out of a business for every dollar you put into it. The general rule is that the more cash you can get per dollar of investment, the better the business is. Now, whether the cash you are investing into the business is called an "expense" and simply deducted from revenues (like Cost of Goods Sold or Sales, General & Administrative expenses on the Statement of Income) or whether those expenses are "capitalized" and turned into an asset that is placed on the Consolidated Balance Sheet, ROIC can let you see how well the company is actually doing, independent of the accounting method chosen by a company's management.
Looking at ROIC tells an investor how efficiently the company is being run and how much cash is being generated per dollar of investment, independent of how management chooses to finance the company. Whether the company is financed with equity (by selling stock) or debt (by drawing on a bank line of credit or selling debt directly to interested investors), ROIC doesn't care. The idea is to have some sense of what the company's operating performance is regardless of the particular way that the company has financed its invested capital. This allows you as a potential shareholder (and business owner) to discern between the actual operating performance of the business and the side effects of how that business was financed.
You want to look at operating performance independent of financing because conventional accounting does not treat all financing costs equally. While interest, the cost of debt, is reflected on the income statement, the more intangible (but no less real) cost of the equity capital is not reflected at all. What? You mean equity costs money? You bet your sweet belled cap it does! When a shareholder like yourself gets equity (or stock, for those inclined toward the less pretentious version), do you expect that the stock will increase in value? How much do you expect it to increase in value? That percentage increase is the cost of equity capital -- if investors do not get the return they expect, they will sell the stock to a new investor, who comes in expecting to earn his target return on the lower share price. The consensus expectation of all investors who own the stock is the cost of equity capital. Just because it is not deducted out of earnings like debt doesn't make it any less real.
This is why ROIC is so powerful. ROIC looks at earnings power in the context of how much capital is tied up in a business and what sort of return that capital is generating. The whole idea of "earnings growing by such-and-such" takes on less importance as a stand-alone concept when you're looking at how much capital is being poured into a business. It is real easy to grow your earnings by investing more money into the business. However, it is not quite as easy to grow earnings by investing capital if you intend to maintain your current level of return on invested capital. A basic illustration is in order.
Say there's a company that is able to grow operating earnings by 20% per year for six years, and you purchase it a P/E of 10. "Such a deal," you might think. The conventional wisdom of investing teaches that P/E is a determinant of value and that a company growing at 20% per year should be worth far more than 10 times trailing earnings. However, while you're focusing on all that earnings growth, you might miss a deteriorating underlying trend of declining economic performance -- or in English, you may not notice that return on invested capital is dropping like a stone as the company invests in projects that earn smaller and smaller returns.
| | After-tax operating earnings | Invested Capital | ROIC | Operating Earnings Growth |
| Year | | $500 | | |
| 1 | $100 | $600 | 18.20% | 20% |
| 2 | $120 | $740 | 17.90% | 20% |
| 3 | $144 | $999 | 16.60% | 20% |
| 4 | $172.80 | $1,398.60 | 14.40% | 20% |
| 5 | $207.36 | $2,097.90 | 11.90% | 20% |
| 6 | $248.83 | $2,986 | 9.80% | 20% |
| 7 | $298.60 | $3,881.80 | 8.70% | 20% |
(ROIC is calculated on average invested capital for each period)
At the end of the period, the company's operating income is 199% higher than in year one. However, the company is currently investing in new projects that earn far less than what the original, core business did. In fact, given how low ROIC has dropped, the new projects are probably earning only 5% to 6% -- about what an investor can get in 100% secure, U.S. Government-issued 30-year bonds. What kind of Fool would be happy that management is investing new money at a rate of return that an investor can get in a bond? Not very many, which is probably why the stock only trades at 10 times earnings.
The above company hasn't built shareholder value because it has invested in projects with ROIC that is below the rate of return investors expect. That's because it has had to increase capital invested in the business at a faster rate than earnings and revenues have grown. Receivables, inventory, building warehouses, and other capital assets such as presses and trucks have all been necessary investments to create the 20% earnings growth that shareholders have demanded. Over the intervening years, the company has had to take on lines of credit, issue commercial paper, and issue long-term debt and preferred stock to finance the expansion because internally generated funds were not sufficient to finance the growth. In spite of the fact that management has focused on earnings growth, the horrible returns on new capital being invested in the business are causing smart investors -- "lead steers," as Bennett Stewart calls them in his book -- to look elsewhere.
What exactly are these "lead steers" looking for in a company? These investors want a company that is "beating" its "cost of capital" -- investing new money into projects that have ROIC that is higher than the expected returns shareholders demand. How do you compare ROIC to the cost of capital? This is what we will examine in part 5.
> ROIC - Equity Isn't Free <
In Part 4, we looked at an example of a company that earned a steadily declining return on the capital invested in its business. At the end of year 7, the company had after-tax operating earnings of $298.60 and was barely beating its cost of capital. By this time, the company had $1,791.60 in equity capital and $2,090.20 in debt (together, they equal invested capital at year-end).
If investors only considered the cost of debt, then it would look like the company was adding value to the capital at its disposal because earnings before interest and taxes in year 7 would be $459.38, much higher than the cost of debt with average debt of $1,791.61 (at 10%) in use in year 7. With that debt load, the company's interest expense would be $179.16 in year 7, giving the company interest coverage of 2.56 times, well within the comfort zone. After a tax savings of $62.71 (35% of interest expense, which is to say, the company's tax rate times its interest expense) that the company receives from using debt rather than equity, the cost of debt capital is $116.45.
However, even though the cost of equity does not show up on a company's income statement, it is not free. Investors expect a rate of return on equity that is in line with the S&P 500 and that also takes into account the specific risks of the company in question. In this case, we have a company that has an average debt-to-equity ratio of 109% in the year 7 and may also be operating in a slower-growth industry with poor economics to begin with. In that case, we would demand a rate of return on equity of about 1.2 times the S&P 500's historical return to compensate for the extra risk. That means that the equity being used by this business will cost it 13.2%. A lower return on equity will hurt the valuation of the company's equity and ultimately the multiple the market will pay for all the capital invested in the business as well as its earnings and cash flow.
Over the course of the year, the example company has $1,642.30 of equity in use. At 13.2% (the company gets no tax savings on this, since earnings attributable to equity are taxable), the cost of equity in use over the course of the year is $216.78. Combined with the after-tax cost of debt, the company's total cost of capital is $333.23, far less than the company's return on invested capital. The proof of this is found in calculating the company's weighted average cost of capital on a percentage basis. Average capital in use over the course of the year equals $3,433.90. Average equity amounts to 47.826% of average invested capital and average debt amounts to 52.17% of average capital. Therefore, the 47.826% of the capital costs 13.2% and the other 52.17% of the capital costs 6.5%, both after tax. To work out the weighted average cost of capital (WACC), multiply 0.47826 by 0.132 and add that to the product of [0.5217 x 0.065]. That equals 0.097041, or 9.7041%. Multiplying WACC by average total capital in use throughout the year, the cost of capital for the company was $333.23.
In this case, the company should trade below the value of its capital because it will continue to destroy value. If the enterprise were priced at one times invested capital, the equity value of the company would be equal to invested capital minus net debt, which puts equity value at $1,791.59. Over the course of six years, the stock of the company has appreciated by 79.2%, or 10.2% annually. At the end of the period, the company's price/earnings ratio has shot up to 21.3, which doesn't seem intuitive with net income being so heavily weighed down by net interest expense. However, at this point, investors are paying for a pile of capital and potential earnings and not so much the current earnings. As the company stands at the moment, it will sap away all shareholders' equity and its creditors will take control eventually.
Rather than acting as a stand-alone conception of how well a company is operating, ROIC should be looked at in relation to the company's cost of capital. Companies such as Coca-Cola (NYSE: KO) have operated on this system, called Economic Value Added, or EVA, for a number of years (as have leveraged buyout financiers). The philosophy doesn't make these companies successful -- it's the implementation of it that makes a difference. Not all successful companies operate based on EVA, either. Some managements think in this way to begin with. However, the readers should know that some of the biggest generators of shareholder value over the last two decades have embraced this philosophy. The company in our example would have stopped growing at a certain point to preserve shareholder value, forgoing growth for growth's sake.
At a certain point, as we see in our example, more of the value of the enterprise goes to its creditors than to its shareholders. When ROIC starts to drop (return on marginal invested capital is a good early warning sign of this), investors should pay attention. It can signal anything from a momentary blip in the company's progress to a decay in industry or company fundamentals. Successful companies in more mature industries (the characteristics defining success for companies in hypergrowth industries are much different) generate ROIC above and beyond their cost of capital -- in fact, this is one reason why the S&P 500 is priced the way it is and why it has outperformed the small and mid-cap universes.
Companies in the S&P 500 are simply the creme de la creme of American business and show a better spread between their return on invested capital and the cost of capital they use. In addition, the very good S&P 500 companies are able maintain excellent returns on invested capital even as they increase invested capital year after year, while others rationalize their operations and sell off those units that can't generate the ROIC that they see elsewhere in their company. By dumping such operations, a company's earnings can shrink, but the valuation on the remaining earnings and capital invested in the business can increase so that the company is now worth more.
By looking at a company's financials from the standpoint of ROIC, an investor considers what's going on with both the income statement and the balance sheet. The various ratios that an investor considers (leverage, cash conversion cycle elements, margins, asset turnover) are brought together under the unified ROIC model. ROIC also allows an investor to look through the various accounting choices that a company can make to portray earnings. As most accounting regimes are rich in balance sheet accruals, ROIC is able to identify the real economic return a company generates. Those expenses that don't go into net income stay home on the balance sheet as part of the company's invested capital. So, what doesn't get considered in the numerator in ROIC has to be considered in the denominator.
> ROIC - Cash's Role <
Return on invested capital means different things to different people, because capital is a somewhat amorphous term and the modifier "invested" further complicates things. The main issue that I will address in this last section of the ROIC series is the amount of cash that a company carries and how that plays into the calculation of ROIC.
In Part 2, we explained that the denominator in ROIC -- invested capital -- can be calculated primarily from the liabilities & equities side of the balance sheet or primarily from the asset side of the balance sheet. This stands to reason because the accounting tautology of assets minus liabilities equals owners' equity (A - L = OE) can be restated as assets equals liabilities plus owners' equity (A = L + OE). The capital that can be invested by management can be looked at through either prism (subject to some distortion-corrections in either case), but the amounts of invested capital must agree with one another. At the very least, they must be in the same neighborhood.
Let's review the definition of capital and ROIC put forth in the Parts 2 and 3. The invested capital base is total assets minus non-interest-bearing current liabilities, and the return is after-tax operating earnings. This is the more hardball way of defining the capital base, though. In Graham and Dodd's Security Analysis, return on capital is defined differently. The definition of return on capital in the fifth edition of that venerable tome is net income plus minority interest plus tax-adjusted interest (basically, after-tax operating profit) all divided by assets minus intangible assets (like goodwill or patents) minus short-term accrued payables. We accounted for the intangibles by looking at the difference between financial capital and capital that operating managers can actually lay their hands on, but we don't depart from Graham and Dodd on cash invested in the business. Whether it's funded by liabilities or owners' equity, the cash represents capital that has been invested in the business. However, there is a difference between invested and deployed, which is where some investors and analysts differ in their view of ROIC.
In our original definition of return on invested capital, we defined ROIC as after-tax operating profit divided by total assets minus non-interest-bearing current liabilities minus cash. Some feel more comfortable with this definition because cash represents capital that hasn't been deployed in other assets or represents potential to reduce liabilities or owners' equity. I stand by this definition depending on the application. For instance, when I wrote about Washington, D.C.-area brokerage and investment banking firm Friedman, Billings, & Ramsey Group (NYSE: FBG), I made a distinction between financial capital and invested capital. This was meant to parse the company's performance on capital that it had actually deployed in its business from the huge amount of cash that was sitting on the sidelines waiting to be invested.
Another case where there was a huge amount of uninvested capital was DSP Communications (NYSE: DSP). That company's return on invested capital (assessing ROIC by the most recent definition above) was huge, but its return on all capital invested in the business was much smaller. The most conservative way to look at the company's ROIC performance was to look at ROIC using a capital base that didn't deduct the idle cash. That's because the company apparently could not find outlets into which it could invest that extra cash. If one were to judge the company on the huge ROIC with a capital base that didn't include the cash, one would have bought DSP all the way up to its high. That's a lofty perch that DSP now sits far below.
In the case of a fast-growing company that has issued securities but has not yet deployed the cash from those issuances, we don't want to get too racy with what we consider as excess capital. For instance, Amazon.com (Nasdaq: AMZN) has at various times had a bunch of cash on the balance sheet, but that doesn't mean that we would consider that to be excess cash that an acquirer of the company could take out of the business. But we also don't want to unduly penalize the company's valuation just because we are taking a snapshot of the financials at a time when it has not yet had the chance to invest all the capital that it has at its disposal. A compromise is in order.
Depending on the capital intensity and the speed at which a company can turn inventory into cash (its cash conversion cycle), the invested capital base of the company should reflect only the cash balance that a company needs to have on hand to cover day-to-day cash outlay needs. For instance, most restaurants that aren't going under need to retain very little cash on hand because they operate in a cash business. Their inventory is turned into cash very quickly, while the payables for the inventory operate on a cycle not all that different from any other business with a good credit rating. Boeing (NYSE: BA) or General Motors (NYSE: GM), on the other hand, take much longer to turn a pile of sheet steel or aluminum and a bunch of electronics into a final sale. They need a good deal of cash on hand to cover necessary cash disbursements in the normal course of a business cycle.
The compromise ROIC is thus: after-tax operating profit divided by assets minus non-interest-bearing current liabilities minus excess cash. Excess cash is cash beyond 0% to 20% of revenues. This level is left to the discretion of the investor, but conservatism is the better part of valor here. When some analysts or Barron's Roundtable sorts of people look at GM and say "look at all that excess cash," it's not as if you could go in and buy out the company and pay down the debt you issued to acquire it. And it's not as if the company's profitability should be measured on an invested capital base from which all cash has been deducted.
A company such as GM needs a bunch of cash (8% of revenues) not just to weather business downturns and interruptions such as strikes, but because it takes longer to convert cash into inventory into revenues and back into cash again. On the other hand, a company that turns its cash into inventory into revenues into cash very quickly, such as Costco (Nasdaq: COST), needs less cash to operate. In that case, any cash that it carries beyond 5% of revenues should be deducted from its capital base. Finally, in the case of Microsoft (Nasdaq: MSFT), in which the concepts of gross margin and cost of revenues are largely irrelevant (thus, inventory needs are nonexistent), all cash should be deducted from the capital base.
As a compromise, this can work better and be more flexible than the very hardcore definition of invested capital that I put forth in the original series. Some businesses such as Intel (Nasdaq: INTC) carry a bunch of cash, but an investor shouldn't deduct all cash from its capital base. Just because the company has a good ROIC and good margins doesn't mean that its cash conversion cycle and capital investment needs release it from holding cash on the balance sheet. If it chose to shoot all its cash back to shareholders, whatever short-term debt it would need to finance its working capital would show up in its invested capital base. So, in the case of Intel, its high ROIC reduces the days of sales in cash that it needs to hold, but it doesn't reduce it to zero. 5% of sales in cash is probably a prudent level of cash to hold and anything beyond that can be deducted from the invested capital base.
Source: Fool
Labels: Stock Investing Basics
posted by KaranZ at 7:16 AM
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