Economic performance
Identifying a company as a potential seven-footer
The focus today will be on the metric Return on Invested Capital (ROIC), reckoned by many to be the best ratio to measure and assess a company’s economic performance.
Best business to own creates value
Before we turn to ROIC, let’s reference Warren Buffett. He has written: “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” (Buffett W. E., The Essays of Warren Buffett: Lessons for Corporate America. 1998) p86
There are two sides to this. First, generating large amounts of incremental capital and, second, employing it at very high rates of return. Both are critical.
Let’s add a third side and a separate concept. “A company creates value when the present value of the cash flows from its investments are greater than the cost of the investments.”
This quote is from a 2022 report, Return on Invested Capital -How to Calculate ROIC and Handle Common Issues, October 6, 2022, by Michael J. Mauboussin and Dan Callahan, the Consilient Research duo at Counterpoint Global Insights of Morgan Stanley.
The third side is the idea that investments only create value if they produce returns greater than their cost, in this case, the cost of capital. Buffett covers this off by his requirement of “very high rates of return”.
The separate concept is that the creating of value relates to the present value of future cash flows. This, of course, is how the intrinsic value of a company is determined, the heart of the valuation process. So, it’s the greater spread between the incremental capital generated and the cost of capital that produces greater value to the shareholders.
ROIC is just a number
People call ROIC a metric or indicator. Giving it an acronym or calling it a metric or indicator doesn’t make it any more useful or reliable. Supporting it with masses of data and calculations also doesn’t make it any more reliable.
For those with a quant bent, quantitative analysts, the formula would look something like this:
Where ROIC – WACC > some big number, say 15, = a seven-footer (to use Warren Buffett’s metaphor about building a great basketball team with seven-footers).
There are many problems with the calculation and use of ROIC. There are also problems with WACC, the weighted average cost of capital. But that is for another day.
As for ROIC, let me start with a key question. When an investor has in hand an ROIC for a potential investment which they understand and have confidence in, is that the end point of the process of assessing the quality of the company or is it the beginning? If it’s the beginning, what comes next?
ROIC is calculated from financial statements. Analysts will often adjust the inputs, but those adjustments are always derived from the company’s accounts.
Reflect on this: “…accounting is but an aid to business thinking, never a substitute for it.” Warren Buffett wrote that in his 1986 Chairman’s letter. So, a calculation of ROIC, at its best, it is no more than an aid to business thinking. I use the expression ‘business thinking’ advisedly.
Warren Buffett says that his attitude when buying common stock is to “approach the transaction as if we were buying into a private business…When investing, we view ourselves as business analysts – not as market analysts, not as macroeconomic analysts, and not even as security analysts.” (Buffett, 1998, p.63) Thus, at its best, the use of a metric like ROIC is as an aid to business thinking
A business analysis is as much, if not more, a qualitative analysis as a quantitative analysis. It must be done with common sense and business sense. We must always remain skeptical of the numbers.
So, to answer the question above, when we have a good ROIC for a company and want to use the ROIC-WACC approach, it is the beginning of an investor’s business analysis of the company.
Return on Invested Capital (ROIC) and the investment process
In a June 2023 report titled ROIC and the Investment Process, Michael Mauboussin and Dan Callahan offer some great insights. Let’s reflect on three quotes from that report.
“A company creates value when its ROIC is in excess of its cost of capital.”
“…two companies may have the same five percentage point positive spread between ROIC and WACC, but the company that can invest more at that spread will create a greater amount of value.”
“ROIC helps us understand the free cash flows of tomorrow, which is important because the value of a financial asset is the present value of future free cash flows. Free cash flow for a given year equals NOPAT minus investment in future growth. NOPAT is the numerator of ROIC and change in invested capital is the investment in future growth. If you have a good estimate for ROIC and a forecast for growth, you have the ingredients to estimate free cash flows.” (Emphasis added)
I’ve introduced a new acronym –NOPAT. This is net operating income after taxes. More on this below.
The formula
ROIC = NOPAT (operating income after taxes) / Invested Capital (Book Value of Equity + Book Value of Debt – Cash & Marketable Securities)
I’ll let Mauboussin and Callahan explain this: “NOPAT, the numerator of the ROIC calculation, is the cash earnings a company would have if it had no debt or excess cash. That means that NOPAT, unlike earnings, is the same whether a company is financed with all equity or if it has a lot of debt. Removing the issue of capital structure allows for effective comparison between businesses.”
“The calculation of NOPAT starts with operating income, or earnings before interest and taxes (EBIT). You then add amortization from acquired intangible assets (A) and the embedded interest component of operating lease expense. Operating lease interest expense 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.” (Mauboussin and Callahan, 10/2022)
Problems with ROIC
There are a host of problems with ROIC. I’ll list them in order of seriousness from least serious to much more.
Problem 1
“ROIC is straightforward in principle but requires numerous judgments in implementation. Shoddy calculations are common.” (Mauboussin and Callahan, 10/2022)
Problem 2
Different folks define ROIC differently. I’ve seen this one, for example: Return on invested capital (ROIC) = quarterly average, net operating profit after tax (NOPAT) adjusted for non-controlling interest, non-service pension, acquisitions and divestiture earnings, one-timers, restructuring, material one-time tax charges and the impact of foreign exchange fluctuations /invested capital, adjusted for accumulated other comprehensive income, cash and equivalents, acquisition and divestiture borrowings, short-term borrowings and material one-time tax charges.
This kind of fine tuning may be all well and good to plug into the compensation formula for the CEO but it is unnecessary for investors and in fact is designed to flatter the CEO rather than assist investors, which gives the CEO an incentive to game the system to juice ROIC and their own compensation.
Problem 3
As note above, NOPAT, the numerator of the ROIC calculation, is the cash earnings a company would have if it had no debt or excess cash. This may be all well and good to compare two or more companies with more and less debt and debt service payments, but it isn’t helpful in understanding the cash a company can generate if you ignore the interest it has to pay. A company with high debts may appear to have a higher return on its invested capital, if you ignore interest payments.
Problem 4
This next problem relates to the calculation of NOPAT.
We can let Professor Damodaran explain it. Aswath Damodaran is a professor of finance at the Stern School of Business at New York University. His area of focus is corporate finance and equity valuation. He has been described as the world’s foremost expert on the subject of corporate valuation.
In his new book titled The Corporate Life Cycle – Business, Investment, and Management Implications published in 2024, he writes: “While the accounting return (return on equity or capital) is easy to compute and reflects data that should be easily available for any business in its financial statement (earnings and book value), its weaknesses lie in its accounting roots.”
He goes on: “When accountants misclassify expenses…as they continue to do with R&D expenses, a capital expense if you follow first principles but one that is treated as an operating expense – the accounting earnings can be skewed significantly.” (Damodaran, 2024) p.132 (Emphasis added)
What this means is that accounting earnings are artificially depressed to the extent of major corporate investment in intangibles of lasting value. This reduces accounting earnings and upsets the reliability of NOPAT calculations. Adjustments have to be made. But the adjustments are problematic. Investors have no way of knowing what R&D expenses actually create intangibles of lasting value. It’s not like buying a building of bricks and mortar.
Mauboussin and Callahan weigh in on this: “We calculate ROIC two ways. The first is the traditional approach, where we derive NOPAT and invested capital from the financial statements that companies report. The second includes an adjustment that considers some fraction of research and development (R&D) and non-R&D selling, general, and administrative (non-R&D SG&A) expenses, as intangible investments. We reflect these investments on the balance sheet and amortize them over their assumed asset lives. The percentage of R&D and non-R&D SG&A that are treated as an expense, as well as the asset lives, vary by industry. This adjustment increases NOPAT and investment (and by definition invested capital) but leaves free cash flow unchanged.” (Emphasis added)
That is, they add back some portion of R&D outlays that have reduced accounting earnings and thereby increase accounting earnings and thus NOPAT.
“Measuring ROIC accurately has become more of a challenge in recent decades as the result of the rise of intangible investments relative to tangible investments. Internal intangible investments appear as an expense on the income statement but do not show up on the balance sheet, which means that earnings and invested capital are understated. To correct for this, we capitalize intangible investments and amortize them over an estimate of their useful lives.” (Mauboussin and Callahan, 06/2023) (Emphasis added)
Problem 5
The calculation of a company’s ROIC requires numbers for both ‘return’ and also ‘invested capital’. Problem 4 dealt with difficulties around calculating NOPAT. That discussion led into the problem around invested capital. As Mauboussin and Callahan put it: “We reflect these investments on the balance sheet and amortize them over their assumed asset lives.”
Does this do the trick? Does it solve the problem that in a world of companies with most of their assets classed as intangible, a lot don’t show up on the balance sheet?
Why is this important? Let’s turn to Warren Buffett. Even before the rise of the magnificent seven, he was onto the importance of asset light companies.
He wrote twenty-five years ago: “[Tangible] asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.
In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined Intangibles of lasting value with relatively minor requirements for Tangible Assets.” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America. 1998) p176 He could have written this yesterday with reference to the tech giants that have appeared onstage since 1998.
Mauboussin and Callahan offer the same thought: “Firms with high ROICs, sometimes called “superstar” firms, have been the most aggressive in investing in intangible assets. Including internal investments in intangibles would lower the ROICs for many of these companies.”
This creates a situation where, on average, companies that are tangible-asset-intensive have high NOPAT and high invested capital and companies that are intangible-asset-intensive have low NOPAT and low invested capital. If you have heard of an executive or investor refer to a business as being “asset light,” you are safe to assume the company invests largely in intangible assets.”
Problem 5 – Let’s put some numbers on it
Mauboussin and Callahan have done some calculations to see what impact there is on ROIC in making an adjustment that considers some fraction of research and development (R&D) and non-R&D selling, general, and administrative (non-R&D SG&A) expense as intangible investments.
They looked at the numbers for Microsoft for fiscal 2020-2022. “When we recalculate ROIC we see the number goes from 49 percent (on the left of exhibit 14) to 34 percent (on the right). The adjusted ROIC is still fabulous but it’s considerably more modest. This is consistent with academic research.”
Problem 5 is even bigger than that
The problem is that even after adjusting invested capital to capitalize investment in intangibles of lasting value, the exercise doesn’t pick up the real value of the company’s intangible assets. The company’s fiscal year end 2022 balance sheet put shareholder’s equity at $166,542 million, or rounded to $167 billion. This is the value the company’s books put on the common shares of the company.
One way to think about this is to see what price the stock market puts on the equity of the company. At 2022 fiscal year end the stock market put a price on the common share of approximately $1.85 trillion. We know that stock prices and stock values are not the same thing. But they do bear some relation and over time one should reflect the other.
We can use market cap as a stand in for the value of the intangible assets of the company. Think of it this way. If Microsoft were sold to a single company at the price set by the market, the buyer would book the excess price over balance sheet assets as accounting goodwill, i.e. as intangible assets which would appear on the balance sheet of the buyer as such.
Management of Microsoft have intangible assets to employ in the business that are not recognized on the financial statements and the best way to understand the value of those unrecognized intangible assets is to see what price the stock market places on them.
The unadjusted ROIC calculation puts Microsoft’s 2022 ROIC at 49%. The adjusted ROIC comes in at 34%. If we use the market cap of equity as a stand in for Invested capital, the ROIC is 4.32%.
If we get into ways of putting a fair value on a company’s equity, we have moved away from ROIC and into the realm of ROCE (return on capital employed) and simple ROC (return on capital). But, changing the metrics used doesn’t solve the problems I have noted.
The solution
Let’s come back to the quote from Warren Buffett that I started with: “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” (Buffett W. E., 1998) p86
Let’s do a business analysis not using any metrics. Remember, in this analysis we are leaving aside the question of price. We are not trying to put a value on the company. We are just trying to decide if the company is one that “over and extended period can employ large amounts of incremental capital at very high rates of return.”
We can look at Microsoft again. This time not through the eyes of ROIC and WACC. I have no axe to grind. I have never owned Microsoft stock. We will use the company’s accounts as an aid to the analysis.
Microsoft Corporation
Microsoft Corporation is a technology company. The Company develops and supports software, services, devices, and solutions. It currently has a market cap of USD 3.2 trillion.
In its last twelve month report that ended June 2024 it recorded $44.48 billion in capital spending. During this same period, it incurred $29.51 in R&D expenses, all of which was expensed and served to reduce reported income. Much of the capital spending would have been on tangible assets. A limited amount of the spending on intangibles of lasting value would have been capitalized and included in the capital spending figure. Much of the R&D spending would have created intangibles of lasting value but they do not and will not appear on the balance sheet.
It is apparent from the numbers below that Microsoft is growing its revenue, operating income and operating cash flow. From its growing operating cash flow, it is able to fund growing capital spending and also fund growing R&D expenditures. Of note, it seems to be able to maintain and even improve its operating margins. It is easily able to fund the capex needed to maintain it long-term competitive position in its various markets. It is also easily able to fund the capex it chooses to make to grow the company and fund healthy R&D expenditures. That is, it seems to be a company “that over an extended period can employ large amounts of incremental capital at very high rates of return.”
In addition, in its last fiscal year, it had $72.5 billion of free cash flow to do with as it chooses. All of these investment decisions call on the capital allocation skills of management. It’s a cash machine.
The balance sheet as at June 30, 2024 shows $268.5 billion of shareholders equity which includes $27.60 billion of intangible assets net of depreciation. Here’s the kicker. Currently the market cap is $3.2 trillion. The stock market is pricing shareholders equity at $3.2 trillion. The balance sheet values shareholders equity at $268.5 billion. So, naturally, a metric like ROIC that uses shareholders equity in toting up invested capital or capital employed, it going to be distorted by the huge amount of equity capital that isn’t shown on the balance sheet.
Fiscal 2016 2017 2018 2019 2020 2021 2022 2023 2024
Revenue(Bil) 85.32 89.95 110.36 125.84 143.02 168.09 198.27 211.92 245.12
OperatingIncome (Bil) 21.29 22.63 35.06 42.96 52.96 69.92 83.38 88.52 109.43
OperatingMargin (%) 24.96 25.16 31.77 34.14 37.03 41.59 42.06 41.77 44.64
OperatingCash Flow (Bil) 33.33 39.51 43.88 52.19 60.68 76.74 89.04 87.58 118.55
CapitalSpending (Bil) 8.34 8.13 11.63 13.93 15.44 20.62 23.89 28.11 44.48
FreeCash Flow (Bil) -30.01 -37.99 11.79 34.39 46.72 57.05 64.70 61.86 72.25
Source: Morningstar
Conclusion
As I noted at the beginning of this post, metrics like ROIC can be useful in assessing the investment merits of a company. There are problems as I have noted. Screening stocks based on a high ROIC and a high spread between ROIC and WACC is a valid exercise to get started. But ultimately, investors need to assess the ability of the company to generate the cash needed to maintain the company’s current market position and also invest that incremental cash in growth at very high rates of return. Inspecting a number of years of financial data from a company are also a good aid to a business assessment of its investment merits. And there is more that should be done, but this is also a good start.
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Not all cash flow generators are superb companies. In the following recent post I looked at a stock popular with dividend investors that didn’t make the cut; even with $3 billion a year in free cash flow.
How to distinguish a superb value creator from an also ran
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