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Today, we will learn more about:

1. Introduction to ROIC

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How to calculate ROIC

I started reading this paper about ROIC and wanted to include highlights in this newsletter, but I quickly realized there was too much interesting content for a single newsletter. Therefore, this week we will learn the basics (don’t worry it is quite interesting and I learned a lot) and in the next few weeks, we will dive into the consequences and more advanced details.

Let’s start from the basic that most of you probably know, return on invested capital (ROIC) is defined as = Net operating profit after taxes (NOPAT) / Invested capital (IC)

The idea of this metric is to understand whether a company is creating value with its investments. Using capital for investment presents an opportunity cost (what other return could I generate with that capital, also known as WACC) and therefore the idea is to compare the return generated by investing in the company with my opportunity cost. Let’s see this was a basic example.

A company invests $10,000 and the opportunity cost is 8 percent. In the first scenario, the investment generates a cash flow of $500 per year into perpetuity, which equals a value of $6,250 ($500/.08). This example illustrates why positive earnings do not always equate to value creation. In fact, we would be better off avoiding this business and investing our money at 8 percent. In this case, growth is not helpful unless growth enables a higher return on capital compared to current levels.

In the second scenario, the business earns $800 in cash flow per year, making the investment worth exactly the cost of $10,000 ($800/.08). This business is value neutral (meaning it does not create or destroy capital). In this case, growth does not affect value creation (In this case, growth is good (as long as return on capital stays constant).

In the final scenario, the firm produces a cash flow of $1,100. This company creates value, as the $10,000 is worth $13,750 ($1,100/.08). In this case, growth is good (as long as the return on capital stays constant). The faster the company can grow while sustaining these returns, the more value it creates.

How to calculate net operating profit after taxes?

The first half of computing this metric is to calculate NOPAT (Net operating profit after taxes). This corresponds to the cash earnings a company would have if it had no debt or excess cash (meaning it is capital structure neutral meaning that NOPAT, unlike earnings, is the same whether a company is financed with all equity or if it has a lot of debt).

In practice, the calculation of NOPAT starts with operating income, or earnings before interest and taxes (EBIT). You then add amortization from acquired intangible assets and the embedded interest component of operating lease expense (which is added back because it is a financing cost rather than an operating expense). Finally, you subtract cash taxes, which include the tax provision, deferred taxes, and the tax shield. Let’s look at this formula in more detail.

Depreciation and Amortization

Depreciation: The first question you might be asking yourself is why to add back amortization of acquired intangibles but not depreciation even though both are non-cash charges. The answer is that depreciation is correctly considered an operating expense because it reflects the usage of physical assets. For instance, a company that buys a machine with a useful life of five years will record it in property, plant, and equipment (PP&E) on its balance sheet and depreciate the asset on the income statement over its life.

Amortization: amortization of acquired intangibles reflects a different accounting. Assume a company acquires an intangible asset like a customer list. The company would post the list as an intangible asset on the balance sheet and amortize it over its estimated useful life. The difference is that for this asset the company spends money to maintain and grow the list and this is an expense on the income statement.

Tangible and acquired intangible assets both lose value, but because the company expenses its investment to replenish the intangible assets, we don’t want to penalize the company twice, first through amortization and second through investment in intangibles on the balance sheet. The appearance of the customer list on the balance sheet is a one-time event as a result of the acquisition, and spending for future maintenance and growth reverts to the income statement.

This topic is a bit confusing so let’s continue with the above example to understand.

• Reality: As the machine decreases in value, the company will invest in a new one/upgrade the old one and that cash outflow will be reflected in the cash flow.

  • Income statement impact: in order to reflect the use of the machine over time, we will just include the depreciation expense

• Reality: As the customer list decreases in value, the company will invest in marketing expenses to maintain its value.

  • Income statement impact: marketing expenses are included in the income statement but so is the amortization of the intangible asset, therefore we have a double impact. This problem is solved by adding back amortization.

Interest component of operating lease expense

Adding back the embedded interest from the operating lease expense is a relatively new adjustment. Starting in early 2019, most companies reporting under U.S. Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) must reflect leases on the balance sheet. Under GAAP, the entire lease expense, including interest, is still expensed. Under IFRS, the lease payments are appropriately allocated between depreciation and interest expense.

For companies reporting using GAAP, you need to separate lease payments into these two parts and reflect depreciation as an expense, and treat the embedded interest expense as a financing cost. That means the embedded interest expense is added back to EBIT to calculate NOPAT.

Let’s see another example to better understand:

• Reality: a retailer needs a store to operate

  • Scenario 1: the company buys a store and finances it with debt. It would record the store as an asset and the debt as a liability. It would then subtract interest expense, a financing cost, from operating income. No adjustment is needed here to calculate NOPAT.

  • Scenario 2: the company leases that same store. It would also reflect the store on the asset and liability sides of the balance sheet according to the new accounting standard. But the lease cost would be recorded as an operating, rather than a financing, expense. The adjustment here is to reclassify the embedded interest portion of the lease cost from the operating section of the income statement to the financing section. This means that we add back the interest to NOPAT since we are not including financing costs.

Taxes

Cash taxes include the tax provision, deferred taxes, and the tax shield. Let’s look at them in detail:

1. Tax provision: Start with what you see on the income statement, but make sure you adjust the figure for unusual items such as restructuring charges.

   1. Note: If you are estimating taxes for a company that spends a lot on R&D, note that the Tax Cuts and Jobs Act of 2017 (TCJA) requires R&D spent in the U.S. to be amortized over five years instead of being expensed immediately. This went into effect in 2022.

      1. Example: Northrop Grumman, an American aerospace and defense technology company, estimated its cash taxes would increase $1 billion in 2022 as a result of the change (since just 1/5 of the total amount was expensed immediately, the company had higher pre-tax income and paid more taxes).

2. Deferred taxes: I plan to dedicate a future post to this topic so I will keep this brief. The main idea is that companies maintain two sets of books, one for

   financial reporting and the other for tax purposes. Difference accounting policies are adopted which lead to a difference between cash and book taxes. One way to estimate deferred taxes is to calculate the year-to-year change in operating deferred tax liabilities minus deferred tax assets.

3. Tax shield: this arises from the deduction associated with interest

   expense. The tax shield reflects the difference between the taxes the company actually paid and the higher taxes it would have paid had it been financed solely with equity. While this benefit is removed in the calculation of NOPAT, it is

   reintroduced in the estimation of the cost of capital.

   1. The tax shield, calculated as net interest expense times the marginal tax rate, increases cash taxes for levered companies and puts all companies on an equal footing.

      1. Note: the TCJA mentioned earlier also set a limit on the tax deductibility of interest at 30 percent of EBIT that went into effect in 2022.

How to calculate invested capital?

Invested capital can be calculated in two ways. The first is the net assets a company needs to generate NOPAT. This is the most intuitive method which is what we will focus on. The second is how the company finances those net assets, typically through a combination of debt and equity.

Invested capital = Net working capital (Current assets - Non-interest-bearing current liabilities) + Net property, plant, & equipment + Acquired intangibles + Goodwill + Other

Net Working Capital

Current assets will be mostly made up of accounts receivables and inventory. You should subtract excess cash and marketable securities in your calculation of current assets as these are financing items. Non-interest-bearing current liabilities, also known as NIBCLs, are basically all current liabilities that are not debt/form of financing.

Net property, plant, & equipment + Acquired intangibles

Next, we add net property, plant, and equipment (PP&E), which reflects gross investment in PP&E less accumulated depreciation. PP&E is a tangible, non-current asset. Some companies also invest in internal-use software. Even though this is an intangible investment, you should treat it the same as PP&E (this intangible investment is amortized over its useful life).

Leases longer than one year also appear on the balance sheet. On the asset side, it shows up as a right-of-use asset, which is the lessee’s right to use the asset over the duration of the lease. Accountants quantify it by estimating the present value of lease payments.

Next, we add intangible assets that are recorded on the balance sheet following an acquisition. Accountants recognize an item as an intangible asset if it arises from contractual or other legal rights or can be separated or divided from the company. Acquired intangible assets are amortized over their estimated useful lives.

Goodwill + Other

Goodwill captures the acquired assets that don’t meet those criteria. Goodwill is basically the purchase price of an acquisition minus the fair value of tangible assets and identifiable intangible assets net of liabilities. Goodwill is not amortized, but companies must periodically test goodwill for impairment. A company takes an impairment charge when it deems the fair market value of goodwill to be below its carrying cost.

Finally, we include any other long-term operating assets. The key to estimating invested capital is to reflect all of the assets the company needs to run its business. There are a number of nonoperating assets that should not be part of invested capital but do need to be reflected in valuation. These include:

• excess cash and marketable securities

• equity investments in other companies

• non-consolidated subsidiaries and finance subsidiaries

• overfunded pension funds

• tax loss carryforwards

In today’s post, we learned the basics of ROIC, in the future, we will learn more advanced concepts related to this financial metric.

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