Metrics are a favorite topic of finance and accounting folks. If you had ever looked down to the right in the “Most Popular Posts” section for Treasury Café, two of the most popular items for a long time were related to the calculation of metrics (Cash Conversion Cycle, Collection Effectiveness Index).
In terms of evaluating organizational performance and its value to investors, the basic building block is Return on Invested Capital, or ROIC.
Why ROIC is a Good Place to Start
The ROIC metric is the basic place to start for a number of reasons:
· The ROIC metric is free from the distortion (and crafty earnings manipulation by CFO’s) of financing activities, such as levering up the balance sheet, hiding debt in operating leases, etc.
· The ROIC metric standardizes (to the extent possible) performance across firms allowing for an “apples to apples” comparison between companies or business units within a company
· The ROIC metric can be subsequently decomposed into several value drivers, allowing for insight into future management decisions and granular evaluation of contribution by different organizational functions
· The ROIC metric is directly tied to the firm’s valuation, which is based on discounted cash flows
· The ROIC metric can be used to compare performance to the company’s cost of capital
The Overriding Principle
The main point to remember about ROIC is that it attempts to measure the return to those who have invested capital. Put another way, it measures the cash coming back to those who expect a return on their cash investment.
As an investor, this is what you want to know. If you give me ²100 to manage (for those new to Treasury Café, the symbol ² stands for Treasury Café Monetary Units, or TCMU’s, freely exchangeable to any other currency of your choice at a rate of your choosing) and expect to earn 10%, which scenario would you prefer at the end of year 1?
· Receive ²10 in cash
· Receive ²2 in cash, and ²18 in “earnings”, which will never materialize back to you in any form during your or your beneficiaries lifetime
Earnings don’t pay bills. Try going to the grocery store and buying food with your “earnings”. The grocery store does not care, it will only accept what you have in your pocket. Cash pays bills. To those who like cash (which savvy investors do), ROIC is your friend.
Why “As-Is” Financial Statements Don’t Work
An organization’s financial statements are a product of an elaborate body of knowledge known in the United States as Generally Accepted Accounting Principles (GAAP) and a lot of places elsewhere as International Financial Reporting Standards (IFRS).
Because there are a set of principles involved that are not directly related to cash but to the protocol of reporting and presenting numbers, what develops is inconsistency between the accounting presentation and what we are concerned about when calculating the ROIC metric. This is nothing against accountants, but simply a recognition that different things about the numbers are important to different people, depending on their perspective.
For this reason, we need to make some adjustments to the financial statements in order to get a good Return on Invested Capital calculation.
For purposes of this post, I thought it would be fun to use an example, so I looked through a listing of Chicago based companies. As a fan of the food and agriculture business I settled on John B. Sanfilippo & Son (link is to the 10-K if you want to follow along).
Step One: Start With Return on Equity
Step Two: De-leverage the Rate of Return
Our objective in calculating ROIC is to arrive at a measure that reflects the firm’s performance for capital invested, no matter whether that investment comes in the form of debt or equity.
Debt can add value in the form of reducing taxes, though at some increased risk of financial distress (see “Costs of Financial Distress and Financial Strategy”). However, de-leveraging accomplishes three things:
· it makes comparisons between periods, or between firms, apples to apples
· it is consistent with the Modigliani-Miller theorem which states that the financing of a firm is irrelevant (see “Will the Real Capital Asset Pricing Model Please Stand Up – Part Two” for a brief discussion of this and a link to the theorem)
· it allows us to compare ROIC to our Weighted Average Cost of Capital (WACC)
In addition, since operating leases reflect an investment by a party that expects a return on their capital, we also include this in the calculation. This can be tricky because the financial statements do not specifically break out what the interest and capital components of this item are.
For purposes here, we use the “rule of thumb” approach. This approach is often used by outsiders such as ratings agency analysts, securities analysts, and others to approximate the additional debt-like obligation of the firm. PricewaterhouseCoopers in their leasing study use a 7 times multiple to establish the principal amount of the operating lease for debt calculation purposes.
From the top of page 56, in 2010 operating lease payments were $1,403 and in 2011 were $1,862. Multiplying these by 7 results in the numbers shown in Figure E.
Step Three: Eliminate Impact of Other Financing Distortions
There are other Balance Sheet categories that can contains amounts that reflect capital deployed that expect a rate of return. Examples of these are:
· Preferred Stock – these investors are paid a dividend in return for their investment
· Minority Interest – these reflect investments in subsidiaries that are not under our direct control, but for which we expect a return
I did not see any items that would be indicative of these categories on the Sanfilippo balance sheet or income statement.
Step Four: Eliminate Accounting Distortions
As discussed at the beginning of this post, the balance sheet and income statement contain items that are required by the accounting presentation protocols but we do not wish to incorporate from an investment standpoint.
Some of these items are:
Deferred Taxes – the income statement presents taxes in the form of what is owed for the pre-tax income of the period by virtue of the matching principle. However, the actual calculation of the taxes owed are governed by rules established by the taxing authorities (such as the Internal Revenue Service in the US). Usually these rules are different than the accounting process, so there is a difference between actual taxes paid (i.e. “cash out the door”) and what will be paid when all is said and done (which is when the accounting version of taxes will have been completed).
LIFO – Firms that use LIFO (last-in, first-out) method of inventory valuation reflect higher costs in their cost of goods sold and lower costs on their balance sheets than firms that use the FIFO (first-in, first-out) inventory valuation method. Since we are concerned with establishing how much capital is invested in the business, we want to make sure our balance sheet reflects the most recent cost available. For this reason, we want to convert LIFO values to FIFO values on our balance sheet for purposes of determining invested capital.
Goodwill – Goodwill arises when we acquire something for a value that is higher than the value established by accounting protocols. On page 49, Sanfilippo discusses their purchase of an entity. They assign the purchase price paid to different asset classes using accounting protocols used to estimate “fair value” of these assets. When the fair value of all these assets are exhausted, yet their remains part of the purchase price still unallocated, this goes into the category called “Goodwill”. You might consider it to be the premium paid for something that we believe will generate value that is not fully determinable at the time.
Expenses that are Investments – Accounting rules require firms to expense some categories that are really “investment-like”. The easiest one to think about is Research and Development (R&D). Say we are working on a new drug that will cure cancer. For 3 years we spend ²100 on the research and development of this drug. These costs will be expensed each year of the 3 years. However, in reality what we are doing is investing ²300 in order to generate very, very large cash inflows (a cancer curing drug will be worth billions in any currency!). These expenses are being incurred with the expectation of future gains, as opposed to expenses being made to get the current year’s “beer out the door”. So from an investment perspective, we want to take these expenses out of the income statement and put them on the balance sheet, and reflect the fact that investors are committing capital with the expectation of future returns.
In order to adjust our income statement and balance sheet, we will need to go through the footnotes to the accounting statements with the following questions in mind:
1. Are there non-cash items being amortized or expensed on the income statement that are better reflected as investments? Then eliminate from income statement and add-back cumulative amortizations to the balance sheet.
2. Are there reserves on the balance sheet that do not reflect actual cash out the door? Add these back to the balance sheet, and the change in these back to the income statement.
3. Are there Deferred Taxes? The change in deferred taxes should be added back to income and the cumulative added to invested capital.
4. Are there expenses that look like investments?
Now that we have the steps, we can add them all together to calculate Sanfilippo’s Return On Invested Capital, as can be seen in Figure G. We notice that it is lower this year at 4.1% vs. 6% last year.
Figure H (at the end of this post) is a summary of the steps we have taken, along with the adjustments needed for NOPAT and Invested Capital.
ROIC is one of the best metrics to evaluate corporate performance, since it eliminates much of the non-economic accounting noise and impacts of financial leverage, allowing us to make comparisons within the firm, between firms, and across time. We can also use ROIC to compare against our Weighted Average Cost of Capital.
· How have you or your organizations used ROIC?