For most industrial entities, return on invested capital (ROIC) represents the most important measure of management ability. Projects whose ROIC exceeds its cost of capital, create value, and as value-enhancing projects continue to grow, the results are reflected in the acquirer’s share price. If the executives in charge of the firm’s assets are consistently able to invest in such projects, it represents the most management- proven technique to reward shareholders looking to build long-term value. Improvements in ROIC are seen in companies able to achieve higher margins, stronger cash flow, and low cost of capital.
For entities which operate on minimal capital, we employ a technique which is based on ROIC, but works better, since, as ROIC approaches zero, it results in extremely large, impractical returns, both positive and negative.
As Oracle Corporation, a very successful acquirer, wrote in its 2009 10K report: “We estimate the financial impact of any potential acquisition with regard to earnings, operating margin, cash flow and return on invested capital targets before deciding to move forward with an acquisition.”
When interest rates are low, corporate planners evaluate taking on projects they might not consider when interest rates are higher. The saving on cost of marginal debt might make such projects worthwhile for equity holders. However, if the cost of debt is variable (i.e., tied to LIBOR) and interest rates rise, the project might become unprofitable. For this reason, that possibility is almost always hedged, allowing the enterprise to eliminate that risk.
Return on invested capital is becoming one of the more widely used analyst metrics. It is of particular relevance however, when under competition with the entity’s cost of capital. By itself, only a vital, but often, partial picture emerges. And for entities or divisions of entities which cannot earn a greater return (on projects) on their invested capital than their cost of capital, its value will decline.
The ROIC is not a measure of security valuation. An entity can continue to accept projects which exceeds its cost of capital, but if its valuation multiple is excessive, its stock could very well decline in the short-run.
Entities which are underleveraged may be denying shareholders a higher valuation if they decline projects having a ROIC greater than the after-tax yield on the excess cash and cost of debt.
Corporate managers evaluate the firm and the business units return on invested capital versus those units cost of capital. Underperforming assets typically have a specific period to improve performance before strategic alternatives are considered. The inability to successfully divest or improve the returns on such assets in a timely manner, meaning, if the unit cannot achieve its cost of capital, could have a negative effect on the entire operations of the enterprise, including its stock price. Management attention is diverted to underperforming units in hopes of turning them around or getting them ready for sale. In addition, the process of divestitures could cause strains on the remaining business segments in need of cash to expand or retool their operations.
The theory behind return on invested capital is to present investors and creditors with an accurate measurement of the cash on cash return management has been able to earn. They need to spend cash to purchase assets in the hopes of a cash return greater than the cost to acquire them.
It is for this reason the analyst should not begin with a GAAP measurement such as net income or EBITDA, but rather free cash flow, in the computation of return on invested capital. Creditors, as with stockholders, expect a cash return, which may not be possible with accounting profits.
EBITDA INAPROPRIATE AS A VALUATION TOOL AND IN MERGER ANALYSIS
Return on invested capital, being one of the central determinants of valuation, has clear advantages over the use of EBITDA.
For example, EBITDA:
- excludes important tax payments that represents a reduction in cash available;
- does not consider capital expenditure requirements for the assets being depreciated and amortized that may have to be replaced in the future;
- does not reflect changes in, or cash requirements in working capital needs; and
- does not reflect the significant interest expense, or the cash requirements necessary to service interest or principal payments, on debt.
Even in a merger analysis, for which EBITDA was originally intended, its use is limited. In addition to the above drawbacks, it may not be useful since it:
- does not include share-based employee compensation expense, goodwill impairment charges and other charges which can impact prospective free cash flows;
- does not include restructuring, severance and relocation costs incurred to realize future cost savings and enhance the operations of the entity;
- does not include the impact of business acquisition purchase accounting adjustments;
- does not reflect company sale transaction expenses and merger related expenses, and
- may include other adjustments required in calculating debt covenant compliance such as pro forma adjusted EBITDA for companies acquired during the year.
To begin analysis of the ROIC metric, we first look at how return on invested capital is commonly defined by security analysts and enterprises, as a search on EDGAR, the SEC database reveals. Here too, as with free cash flow, definitions reported in financial statements differ for filers, making comparability often difficult to impossible. As with free cash flow, many firm’s tailor-make a ROIC definition, attempting to both place themselves in a favorable light, and adjust for peculiarities of their business.
A search through the Edgar database reveals a commonly used definition of ROIC to be:
ROIC=(EBITDA+Interest Income*(1-Tax Rate)+Goodwill Amortization)/(Total Assets-(Current Liabilities+Short Term Debt+Accumulated Depreciation))
National Semiconductor, has an even simpler definition, as spelled out in their 2009 10K: “We determine return on invested capital based on net operating income after tax divided by invested capital, which generally consists of total assets reduced by goodwill and non-interest bearing liabilities.”
Not only does beginning with EBITDA suffer from the shortfalls listed above, it is not a measure of distributable cash and is thus not a measure of real return to holders of equity securities. Excluding goodwill, like National Semiconductor, ignores a real cash outflow for which management is expected to earn free cash flows.
A SUPERIOR ROIC METHODOLGY USING FREE CASH FLOW
Using free cash flow as a base allows for comparability, uniformity, and offers what ROIC is really supposed to capture, the cash return on cash spent for capital. A more logical definition for ROIC, and one being proposed for analyst adoption to be:
ROIC= (Free Cash Flow-Net Interest Income)/(Invested Capital (Equity+Total Interest Bearing Debt+Present Value of Leases-Cash and Marketable Securities) )
This more precise definition includes:
- Intangible assets, as those funds were used to acquire cash producing assets
- All interest bearing debt, as they too were sold to purchase productive assets
- Present value of operating leases, as this represents contractual debt in exchange for required assets needed to produce revenue, hence cash flows. To exclude operating leases would be to unfairly boost the return on invested capital and to distort the comparison between companies that buy assets or enter into capital leases and those that enter into operating leases.
- Since free cash flow is used, it includes the payment of cash taxes and the elimination of other accruals.
We do not add back, as true with EBITDA-based measures, interest income to free cash flow as we are attempting to measure the cash return on productive, not financial assets.
Investors, large and sophisticated to small and naive, with the latter often dependent on, and trusting of the former, often fail to understand the complicated relationship between valuation metrics and return on invested capital.
It is easy to want a simplified approach to investing, such as price/earnings multiple or price/book, but quite another to be able to and understand the bearings behind the numbers, and why so many entities sell for what appears to be an incredibly low valuation multiple or ratio.
In essence, entities having a low return on invested capital or dependent on large capital expenditures resulting in small amounts of distributable cash flows deserve low valuation metrics despite their higher rates of growth in GAAP related yardsticks. This is why many investors are fooled having invested in low P/E multiple companies. It is for this reason we advocate adoption of the return on invested capital metric using free cash flow as a base and, in our model portfolio only invest in entities which have shown the ability to consistently produce an average free cash flow yield in excess of the 10 year treasury yield.
Under the cash flow based definition, goodwill, intangible assets, and all other productive assets which required cash expenditure are counted in the capital base. Operating leases should also be included in the capital base, as they represent a financing decision for capital expected to return cash to the firm. We would not, however, impute an interest charge on the operating leases to deduct from free cash flow, as the entire lease payment is deducted in the computation of free cash flow, as reported under operating activities.
You will find by using the more precise and logical definition of ROIC, to be used in comparison to cost of capital, your portfolio will exhibit lower risk and higher returns.
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