Friday, February 17, 2012

A few thoughts on ROIC

"the cash return on cash spent for capital." - Ken Hackel

It never fails, if I include my return on invested capital calculation in a post I will invariably get a few comments or emails questioning it or asking for clarification.  This last post was no exception.

The ROIC calculation I use is a bit unique, but I can't take credit for it.  I use a calculation that Ken Hackel presents in his book Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making.  The book focuses on evaluating companies on a cash flow basis.  This means looking at free cash flow, cash return on invested cash, and sources and uses of cash.

Cash and cash flow are the focus of the book because cash flow based numbers show a true flow of what's moving in and out of a business not an accounting version.  Often the accounting picture can be gamed by adjusting estimates.  Some accounting metrics are just outlandish, my favorite is Adjusted-EBITDA.  It seems every company now has an Adjusted-EBITDA number that only includes good things and excludes any potentially bad items.  I've also noticed that executive bonuses are usually based on these fiction numbers as well.  Quite a nice gig if you can get it!

Ken Hackel gives this reason to use a cash flow based ROIC formula verses a more standard EBITDA/EBIT version:

"In essence, entities having a low ROIC or dependent on large capital expenditures resulting in small amounts of distributable cash flows deserve low valuation metrics despite their higher rates of growth in GAAP-related yardsticks.  This is why many investors are fooled, having invested in low-P/E companies." (Hackel, p252)

Hackel mentions that he searched EDGAR to find the most common ROIC formula that companies use to measure themselves, this was the result:


EBITDA + interest income * (1-tax rate) + goodwill amortization
-------------------------------------------------------------------------------
total assets - (current liabilities + short term debt + accumulated depreciation)



A more accurate cash based version presented in the book is as follows:

free cash flow - net interest income
------------------------------------------------------
invested capital(equity + total interest bearing debt + present value of leases - cash marketable securities)

Hackel provides some reasons why specific values are included in the calculation.  Instead of trying to summarize his points I'm just going to quote him, he says it much better than I would.

"
1. Intangible assets because those funds were used to aquire cash producing assets.
2. All interest-bearing debt because this too was sold to purchase productive assets.
3. Present value of operating leases because this represents contractual debt in exchange for required assets needed to produce revenue, hence cash flows.  To exclude operating leases would be to unfairly boost the ROIC and to distort the comparison between companies that buy assets or enter into capital leases and those which enter into operating leases.
4. Since free cash flow is uses, it includes the payment of cash taxes and the elimination of other accruals." (Hackel, p252)

Of course no formula is perfect and there are a few downsides to this formula.  Activities that go straight to the equity statement such as foreign currency translation adjustments, actuarial gains/losses, changes in fair value of available-for-sale assets/cash flow hedges, and revaluations of property, plant and equipment end up affecting the formula.  These changes would need to be backed out to get an accurate picture of the company's cash return on capital acquired for cash.

When I read this formula in the book it really resonated with me and I've been using it as I analyze companies.  Some investors might consider it a bit too stringent, but I don't mind that.  The formula has come in handy finding companies that end up directing most of their cash to working capital or capex.  I don't want to invest in companies that have great net income numbers but don't have the cash flow to back it up.

Disclosure:  If you purchase the book through Amazon I will receive a small commission.  There is no difference in book price entering Amazon through my link, or on your own.  I received this book as a gift from a family member, the author or publisher has never contacted me.

5 comments:

  1. Hi Nate, I would love to see a post on PSD.TO. A misunderstood stock due to odd accounting rules and a leader in its industry.

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  2. "In essence, entities having a low ROIC or dependent on large capital expenditures resulting in small amounts of distributable cash flows deserve low valuation metrics despite their higher rates of growth in GAAP-related yardsticks. This is why many investors are fooled, having invested in low-P/E companies."

    Depends at what stage the business is in. An earlier stage company may have a large capex so it can grow. This isn't necessarily a bad thing. If you could definitively break capex into growth and maintenance, then the point would make sense if maintenance capex was really high. But that is tough or impossible to do.

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  3. Anon - I agree with you, I like how Marty Whitman puts it, a company can do three things with cash
    1) Expand assets
    2) Reduce liabilities
    3) Distribute equity to owners (dividends/buybacks)

    I don't think there is some sort of ranking system for those, they each have their place. The key is when a company expands assets are they getting an adequate return on those assets?

    I remember seeing a formula for a good way to estimate maintenance capex. Of course the key is estimate, unless management provides it there's really no way to know what the true number is.

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  4. Nate - whats your preferred method of capitalizing operating leases?

    Have you considered capitalizing r&d as well? I would think at least some r&d spend produces a productive asset that is a source of revenue and profit beyond the current year. A lot of tech companies look like they produce amazingly high ROIC until you capitalize the R&D.

    Let me know what you think. THanks in advance

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  5. I use this formula with minor tweaks. I'm a fan of excess cash, working capital & less of a fan of projecting cash into the future. Get back to the basics, equity runs the show & cash follows for the ride. A company can survive without cash but not so much without equity. Cash may be tied up & may even stop flowing while equity keeps the cash going when the cash has stalled. Cash is more of financial health where equity is the worth of that health. The formula for cash works rather well if you like cash projections. For me, I focus more on equity & use ROIC as a measure of health. Together cash & equity go hand in hand & should have a equal focus. Cash may fall or rise as both are good till the financial evidence proves otherwise. Earnings is either fueled by leverage, profitability or assets efficiency & both equity & cash would suggest together it's quality of lack of it. Investing, finances, equity, operations pretty much is everything you need to determine if further research should be done. A ratio is only a peek at the universe, it's secrets aren't revealed till we look inside which translates to a company's financial statements. Ratios should be the first step, a way to filter through a list of stocks. It's not a good idea to buy or sell a stock on the results of a ratio + a ratio is not meant to be precise or perfect. The formula used doesn't matter, what you do next is very important. 2 people looking at the same ratio would take different roads. It all comes down to your experience, personality, awareness, logic which sets you apart from another & in both cases, they are both correct.

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