18/3/2021 Return on invested capital - Michael Mauboussin on investment concepts

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Return on invested capital – Michael

Mauboussin on investment concepts
Minerva Review / 09/03/2019

The one dollar test

Businesses must pass the one dollar test. That is, they must earn a return of invested
capital (ROIC) in excess of the opportunity cost of capital. In their paper, Calculating
Returns on Invested Capital, Michael Mauboussin and Dan Callahan provide a helpful
introduction to the topic. We highly recommend that you read their paper in full if you
have the time. If not, this post will provide a crude summary of it. This includes a look
at return on invested capital as a measure of performance and the nuances to keep in
mind when working with such metrics.

Return on invested capital

Return on invested capital (ROIC) is a measure of capital efficiency and the company’s
overall performance. We can calculate it by dividing a company’s net operating profit
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after tax (NOPAT) by its invested capital (IC). Unlike return on equity, high financial
leverage does not distort ROIC.

ROIC = NOPAT / IC

Net operating profit after tax (NOPAT)

Net operating profit after tax (NOPAT) measures the company’s cash earnings before
financing costs. Technically, NOPAT is earnings before interest, taxes and amortisation
(EBITA), minus associated cash taxes. Additionally, cash taxes should consider tax
provisions, deferred taxes and any tax shields. The effective tax rate for growing
industries is generally more modest due to increases in deferred taxes. We can also
subtract investments (i.e. change in net working capital, net CAPEX and net M&A) from
NOPAT to derive free cash flows (FCF) for discounted cash flow (DCF) analysis.

NOPAT = EBITA * (1 – Cash Tax Rate)

FCF = NOPAT – Investment Needs

Invested capital (IC)

Invested capital (IC) is the level of assets that a business needs to operate. We can
intepret it as the level of financing from creditors and shareholders that the company
requires to support operations. There are two approaches to estimating invested
capital:

1. Assets approach: IC = Net Working Capital + Net Property Plant & Equipment +
Goodwill + Other Operating Assets

2. Liabilities and equity approach: IC = Total Debt + Total Equity + Deferred taxes +
Other long-term liabilities

Net working capital (NWC)

Net working capital (NWC) is the cash level that a company needs over the following
twelve months. Working capital changes are sensitive to company growth rates.

NWC = Current Assets – Non-interest Bearing Current Liabilities

One measure of strength

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ROIC is one measure of company strength and performance. Mauboussin suggests

that companies that earn a consistently high ROIC are likely to exhibit some
competitive advantage and/or management strength. Professor Bruce Greenwald also
dicusses this at length in his book, Value Investing: From Graham to Buffett and
Beyond. Greenwald suggests that companies without a durable competitive
advantage will see incumbents or new entrants drive their ROIC down.

Similarly, it is for these reasons that investors likes to search for companies that earn
consistently high returns on invested capital. In The Little Book That Beats the Market,
Joel Greenblatt describes his ‘magic formula’ of screening for companies that earn
high ROIC, while trading at high earning yields. He believes this is a simultaneous filter
for quality and value, which has seen some empirical success.

Returns on incremental invested capital (ROIIC)

Returns on incremental invested capital (ROIIC) focuses on the relationship between
incremental earnings and incremental investments. It compares the change in NOPAT
in a given year to the change in invested capital made in the year before. Mauboussin
suggests that high ROIIC is an indicator of capital efficiency or high operating
leverage, and can help to inform potential moves in earnings. It is useful to calculate
both ROIC and ROIIC to provide an absolute and relative measure of spending
effectiveness.

ROIIC = (NOPAT_t2 – NOPAT_t1) / (IC_t1 – IC_t0)

Mauboussin notes that a company that achieves an ROIC equal to its cost of capital
should have a P/E ratio that is inverse to the cost of equity. Mauboussin and Callahan
observe that firm ROICs tends to revert to its industry average over time. While the
firm’s P/E ratio is also likely to revert over time, it is the underlying ROIC that drives this
multiple.

Again, some companies may sustain a high ROIC and ROIIC if it enjoys an enduring
competitive advantage. In his book Competition Demystified, professor Greenwald
suggets investors consider the degree and durability of demand advantages (e.g.
switching costs), cost advantages (e.g. technology) and/or economies of scale that the
company might currently enjoy. Similarly, in The Little Book That Builds Wealth, author
Pat Dorsey recommends investors consider the strength of intangible assets, switching
costs and network effects as well.

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Return on invested capital nuances

Mauboussin and Callahan also outline several factors that may affect our interpretation
of ROIC. This includes excess cash, good will, restructures, operating leases, research
& development, minority interests and share buybacks.

Excess cash
Arguably, companies are responsible for all use of capital and should therefore earn a
return on all capital on its balance sheet, including cash and marketable securities.
However, since ROIC focuses on a company’s operating capital efficiency, it can be
helpful to treat issues with ROIC and capital allocation separately. Additionally,
Mauboussin suggests that analysis of invested capital should include only the level of
cash that the company requires to run its business.

Goodwill (acquisitions)
It can be helpful to distinguish between and account for both operating returns and
acquisition returns. This is more so if company mergers and acquisitions involve
payment of large premiums. However, if a company is expected to be less acquisitive
going forward (e.g. change in management), it might be appropriate to exclude
goodwill from invested capital calculations.

Goodwill (write-offs)
When the value of an asset drops below certain value thresholds, accounting
standards may require the business to write off the asset. It might be important to add
back asset write-offs to invested capital to better capture the efficiency of capital
allocation. In other instances, adding write-offs back might not improve the economic
picture (e.g. new management and capital allocation strategy). Some judgement is
required.

Restructuring charges
Restructures often include a non-cash asset write offs and a provision for restructuring
charges (e.g. equipment relocation, headcount reduction, etc.) to capture the cash
outlay. Asset write-offs can be treated in the same way as discussed previously. While
restructuring charges can distort ROIC in the short term, provisions generally do not

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need to be made as accrued restructuring liabilities decline with subsequent cash

outlays.

Operating leases
Operating leases are all lease obligations that are not capitalised or captured on the
balance sheet. Leases should be reflected in ROIC calculations to capture financing
choices, particularly for capital intensive industries. Generally, this involves adjusting
NOPAT by reclassifying lease interest payment expenses as a financing cost (instead
of operating); and adding the implied principal amount of the lease to assets and debt.
Additionally, do keep in mind recent changes to GAAP and IFRS lease standards,
which now require companies to classify operating leases as a liability on their balance
sheet.

Research and development

For R&D intensive companies, it might be to capitalize and amortize R&D to reflect its
long-term expected benefits. We might otherwise understate the earnings and
invested capital used in calculating ROIC. Note that free cash flow and intrinsic value
remains unaffected by such adjustments. Similarly, we also might make adjustments
for companies that underrtake significant marketing in the early stages of its business
lifecycle.

Minority interest
We may have to make adjustments to ROIC if a parent company has substantial
holdings in the company, or if the company has substantial holdings in another. For the
former, tax considerations and size of minority stake is important for valuation
purposes. For the latter, it might be helpful to calculate ROIC by excluding the minority
stake. We can then add the value of the minority stake value back when determining
shareholder value per share.

Share buybacks
Share repurchases do not affect the measure of ROIC if excess cash is excluded from
calculations. If the buyback is paid with cash on the balance sheet (i.e. excess cash
by definition), then neither NOPAT nor IC will change. Similarly, if the buyback is
financed through debt, NOPAT remains unchanged since it is financing neutral. IC also
remains unchanged since the increase in debt is offset by the decrease in equity.

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Further reading
The Warren Buffett Way – Robert Hagstrom on Buffett’s investment tenets

One Up on Wall Street – Peter Lynch on investment principles

The Outsiders – William Thorndike on unconventional CEOs and a blueprint for

capital allocation

Conservative investors sleep well – Philip Fisher on investment principles

References
Mauboussin, M., Majd, D., and Callahan, D. (2014). Capital Allocation – Evidence,
Analytical Methods and Assessment Guidance. Credit Suisse. Available at
<https://plus.credit-suisse.com/r/V6ctdQ1AF-WElY95>

Mauboussin, M., and Callahan, D. (2014). Calculating Return on Invested Capital –

How to Determine ROIC and Address Common Issues. Credit Suisse. Available at:
<https://plus.credit-suisse.com/r/P8BJ3Y>

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