This is the first of three blog posts in which I explain the criteria we look for when considering a company for long term investment: (Do note that for disciplined yearly investments, we follow the Expectations Value Model)
1. Business Quality
2. Business Growth
3. Business Valuation
As investors we are always looking for high quality businesses. Though there is no universal definition of what exactly is “high quality” but businesses that generate more cash/returns/profit than comparable competitors is typically regarded as high quality.
Companies invest in their capabilities to produce goods, provide services or to increase their market reach in their quest to grow. How much investment is needed to achieve this growth determines the quality of the business.
High quality (higher returns) businesses demand premium valuations; sustainability of these higher returns is the key to enduring them. “Return on Invested Capital” (ROIC) is a metric that helps us identify high quality business. At its crux, it gives us the earning power of the company’s investments/assets. Higher the earning power, better the company.
ROIC = Profit from Operations/Invested Capital
Lets define these terms below and more importantly explain the calculation in detail using company’s financial statements.
Remember, we are determining the quality of the core operations of the business. Hence, Invested Capital is the money invested by the business to build its core “Operating Assets”. Operating assets generate “Operating Income”.
Profit from Operations:
This is profit from core operations. Other income, exceptional income and extra-ordinary income should not be included in this calculation. Similarly all non-operating expenses should also be excluded. Typical examples of non-operating expenses include, provisions for bad loans, loss on asset write-off and investment losses. Depreciation and Amortization are real operating expenses (though accountants call them non-cash items), and should be subtracted to get operating profits.
Since ROIC measures returns on all capital (assets) irrespective of how it was funded (equity or debt), we will ignore Interest payments while calculating operating earnings.
The last item is tax. It will be an error if we consider the actual taxes paid by the company, since that will include the tax benefit of the interest payments. We will hence use the effective tax rate to calculate taxes (typically in the range of 25-30% + surcharges).
So,
Operating Profit Before Tax = Earnings Before Interest and Taxes (EBIT)
= Operating Income – Operating Expenses – Depreciation & Amortization
Profit from Operations = Net Operating Profit After Tax (NOPAT)
= EBIT * (1- Effective Tax Rate)
NOPAT and EBIT are widely used operating earnings measure.
Invested Capital:
Before even we define Invested Capital, it is important to understand that we need to use “Beginning Of The Year” Invested capital to calculate current year ROIC. This is because we consider those assets which are in place through-out the year.
Assets created during the year may not start generating returns during the current year. Many analysts prefer using the average of Beginning and End of year Invested capital, I personally prefer using the Beginning of Year values.
Effectively, we use previous end of year Balance Sheet to calculated Invested Capital for the current year.
Invested Capital = Total Operating Assets Funded by the Company
= Total Operating Assets – Total Operating Assets Funded by Other Entities
= Total Operating Assets- Non-Interest Bearing Recurring Current Liabilities
Total Operating Assets:
To calculate Total Operating Assets, go through the entire list of assets on a balance sheet and ask the question, What type of income will this asset generate?:
- Core Operations Income (or reduce operational expense)
- Other Income
- Exceptional Income
- Extraordinary Income
Only if the answer is “Core Operations Income”, include that asset as Invested Capital. Do note that the same asset can generate different types of income for different types of industries. For example, “Loans” will generate Operational Income for Banks but Other Income for a manufacturing company.
The following assets will probably be excluded from the calculations for most of the companies:
1) Freehold Land – Does not generate any income
2) Goodwill – Does not generate any income, it is just an accounting variable to hold payments over book value in acquisitions. The case to include Goodwill is equally strong. It needs to be a judgement call.
3) Investments in Mutual Funds, Fixed Deposits: Income from these sources is included in “Other Income”, it is usually not a part of core operations for any company (except probably banks and financial institutions).
4) Cash: Cash will mostly generate Interest income (other income) and hence will be excluded. Some analysts believe that a part of cash is required to run the operations and hence should be included in Invested Capital, I prefer not considering any cash.
Non-Interest Bearing Recurring Current Liabilities:
By the very nature of any business, some component of the operating assets is funded by other entities. This does not mean the assets are free, but are free to use for a specified duration of time.
Consider raw material; payment terms with the supplier allow some leeway (say 45 days) for the payment of received raw material. This would mean that for 45 days of usage of this raw material, there is no charge to the company. As the current batch of raw material is being consumed and paid for, the next batch arrives with another 45 days of payment window. This continues and the business benefits from use raw material for free.
Some companies initiate production only after part payment/advances are received from the customer. This always helps the business to reduce its invested capital since some capital that is required for production is supplied by the customer themselves.
This is why such payables/dues/liabilities are subtracted from the total operating assets to arrive at Invested Capital.
To identify such liabilities from the balance sheet, verify if they meet these three criteria:
1) No interest is charged on the dues if the payment is made in the specified duration
2) Are recurring (and therefore current) in nature (i.e. the benefit is perpetual)
3) Fund operating assets
Add up all such liabilities to get Non-Interest Bearing Recurring Current Liabilities.
Calculating ROIC is a great way to understand a business and deep dive in its balance sheet and income statement.
ROIC also plays a very important role in predicting future earnings, which in-turn helps us calculate the intrinsic value of any business.
References:
- https://intrinsicinvesting.com/2016/04/12/return-on-invested-capital-why-it-matters-how-we-calculate-it/
- https://intrinsicinvesting.com/2016/10/18/questions-about-roic-valuation/
- http://people.stern.nyu.edu/adamodar/pdfiles/papers/returnmeasures.pdf