Filter #3: Return on Invested Capital (ROIC)
Let’s continue from part 1 where we have already discussed Filter #1 and Filter #2. Filter #3 is about ROIC and it involves 2 parts of calculations for it to be evaluated in a useful manner. The first is calculating ROIC and the second is comparing it to the weighted-average cost of capital or (WACC).
So what is ROIC? ROIC simply measures how EFFICIENT the company is in generating profits from its capital invested. Then you might ask… so what’s the difference between ROIC, Return on Equity (ROE) and Return on Assets (ROA)? Don’t they all measure how efficient the company is in generating profits from its capital invested? Yes, its true but here is the difference.
ROE is net profits / shareholder’s equity and ROA is net profits / average assets. The dangerous part about ROE is that it does not give you a clue on the company’s degree of debt leverage nor does it give you a clue on the efficiency of using debt. Debt is EXCLUDED from the equation and remember what does Warren Buffet say? Always be Hawkish when it comes to debt!
For example, you can have a scenario that a company is generating say $10 million of profits and its shareholder’s equity is $30 million so its ROE would be 33% which is pretty high is’int it. But what if the company has $70 million of Debt, cash flow is tight and it’s falling short of interest payments? The picture suddenly does not look so rosy anymore. Measuring ROE or ROA can sometimes create the distortion that a company is highly profitable but yet in a dangerously leveraged position.
Debt or Financial Leverage works as a double-edged sword. It can be used to generate multiplier returns during economic booms OR force a company to liquidation during economic crises. The reason is because increased debt levels increases the proportion of fixed costs (interest payments) as a percentage of total cost. Hence, any marginal increase in sales revenue after the break-even point of fixed costs would increase net income at a faster rate since contribution margin (Selling price – Variable cost) is higher. Vice versa, any marginal decrease in sales revenue below the break-even point directly eats into the bottom line as fixed costs are incurred irregardless of circumstances.
How’s ROIC different from ROE and ROA then? The main difference is because DEBT is taken into account! The denominator of ROIC is “Invested Capital” and we can understand invested capital by measuring a company’s asset value. Basically it means how much assets the company has invested
to generate profits. In accounting 101, Assets = Liabilities + Shareholder’s Equity. Hence here you notice that Debt (“Liabilities”) are included as part of the denominator, in contrast with ROE where only equity is measured.
If you refer to the above example and compute ROIC, it would now be around 10% ($10 mil / $30 mil + $70 mil), significantly lesser than ROE of 33%, as both debt and equity are now taken into account. I used around because there are certain adjustments to invested capital that would be made as you will see later.
ROA is similar to ROIC but the latter takes a step further to re-define assets. While ROA takes the average of beginning assets balance and ending assets balance, ROIC argues that only “Invested Capital” should be considered as it provides a more accurate representation of capital efficiency. The definition of Invested capital is nothing but Assets +/- all other adjustments.
When we talk about invested capital try to imagine those plants, equipment, machinery in factory etc.that contributes part of a business’s operations to generate revenue. So when you think of cash, cash doesn’t contribute to generating income technically. Cash is just sitting in the bank account earning negligible interest income. With or without cash the company would still be generating the same amount of revenue. Therefore, we EXCLUDE cash by reducing it off from assets in the equation. That’s the first part.
The second part we mentioned that Debt should be included in calculating ROIC. But when you think of invested capital, invested capital should represent the amount of capital that is raised either through debt with contractual obligations such as bonds/bank borrowings or equity such as shares. The company would then used the pooled money to invest in assets that generate economic benefits for the company and its shareholders. Now, if you look at “Accounts Payable” under liabilities, is it really considered a debt? Accounts Payable is not capital raised and it would be inaccurate to represent invested capital. It is merely a method of settlement and it is an obligation that does not benefit or generate economic benefits for the company. Hence, we also EXCLUDE Non-Interest Bearing Liabilities by reducing it off from assets in the equation.
From what we have discussed, the formula for Invested capital is then calculated to be: Invested Capital = Total assets – excess cash – non-interest-bearing current liabilities
Now we are done with the denominator, let’s look at the numerator. ROE and ROA takes net profit as its numerator which is fine. But ROIC has a slightly different approach, it takes Net Operating Profit After Taxes (NOPAT). So what’s NOPAT?
The formula for calculating NOPAT is = Operating profit (EBIT) x (1 – tax rate). Sounds complicated… and it is because this figure is not always available in company’s annual report or quarterly results. The reason for calculating NOPAT instead of net profit is because we want to calculate what is the profit of a company WITHOUT the use of debt financing and utilization of tax benefits. If a highly geared company has tons of debt and high interest expenses, tax expenses can be reduced because interest expense is deductible against operating income. Therefore, EBIT would provide a better representation of underlying company’s operational efficiencies before meeting debt obligations and gaining tax benefits.
Now we have both the numerator and denominator, we can calculated what is the ROIC. The formula for calculating ROIC is = Net operating profit after taxes (NOPAT) / Invested Capital
How to interpret ROIC?
The way to use ROIC is to compare it against the cost of capital. Return on invested capital should ALWAYS be above its cost of capital (WACC) for filter #3 to pass and it should be compared across a period of time to gain an assurance that the company can consistently generate a positive returns from capital received (5-10 years). If it is below WACC, that means the company is destroyer shareholder’s value for every dollar of capital invested into the business.
Using what we have learnt from the book, let’s try to put it into context in a real company (SATS). EBITDA figures are extracted from SGX website and I minus depreciation/amortization expense to get EBIT. The rest of the figures are directly taken from SATS annual report and ROIC is calculated accordingly.
We see that ROIC is consistently above 10% and the WACC approximates around 6-6.5% from various analyst reports. Hence, SATS would have passed filter #3!
Filter #4 Long-term Debt to Free Cash Flow Ratio
Try to kill the company, count the cash and then try to kill the company, think what could go wrong and if we can’t kill it, maybe we’re on to something.
Filter #4 measures the financial health of a company’s debt level, whether the company has the robustness to service its debt (similar to metrics like interest coverage ratio). What the above sentence is saying is that think of all the worst case scenarios and outcomes, and see if the company has the ability to withstand through economic downturns while maintaining its current operating capacity.
Debt. Warren buffet said: “When it comes to debt, I’m hawkish”. One of warren buffet’s checklist for investment is that companies with durable competitive advantage typically have long-term debt burdens of fewer than 5 times current net earnings (meaning that if I am purchasing the company outright, I want to see that the company could pay off ALL of its long-term obligations with cash and current earnings in 5 years or less. 5 years is generally a good checklist to test a company debt obligation, but Warren buffet is more aggressive than that, preferring instead to see a ratio of no more than 3. He wanted a company to be able to pay off all long-term debts within 3 years from current cash flow earnings!
So… what is long-term debt to free cash flow ratio? Long-term debt to free cash flow is an indication of a company’s ability to survive and thrive during a downturn. Highly leveraged companies – those with long-term debt that exceeds years of their annual free cash flow will find it crippling to service its debts during downturns. These are the red flag companies that we should be cautious of before investing in them!
Long-term debt to free cash flow can be calculated as Total long-term debt / Free cash flow. It means how long would it take for a company, assuming free cash flow remains constant, to pay off its existing debt. The lower the number, the better as that means all long-term debt can be repaid in a short period of time.
*Make sure the balance sheet is an iron clad!
Putting all these formulas into a real-company (SATS), let’s see how it turns out! The bar chart below is extracted from SGX.
Looks pretty good. SATS have extremely low Long-Term Debt and ALL its long-term debts can be paid off in less than a year with current cash flow earnings! SATS passed filter #4, easily. We do not have to worry on liquidity issues or servicing its debt during economic downturn.
Summary of the 52-week low formula:
Filter #1: Durable Competitive Advantage: Is the company in an industry with good economics? Does the company appear to have an economic moat that will allow it to fend off competition? Look at Porter’s 5 forces.
Filter #2: Free Cash Flow Yield: Does the company generates free cash flow sufficient to allow for cash distribution while maintaining its competitiveness in the marketplace? Does it have not only positive cash flow, but enough MARGIN OF SAFETY over the risk-free rate to justify the investment risk?
Filter #3 Return on Invested Capital: Does the company invest money in such a way that it generates returns on capital above its cost of capital consistently?
Filter #4 Long-Term Debt to Free Cash Flow Ratio: If something catastrophic happens, can the company service its debts and maintain its production capacity? Can the company pay off its long-term debt with its free cash flow within 3-5 years?
Filter #5 Prices are at 52-week low? If the company has passed all the criteria of filter #1 to #4, then we check if the price is at a 52-week low? If yes, its a value bargain buy that is not noticed by the herd and it represents maximum financial opportunity instead of buying at the top.
And… we have finally come to an end for this series of the 52-week low formula blog post. Hope you will find the posts useful and learned something out from it. It is a recommended book for value, long-term investors or for anyone who just want to analyze companies using system 2 thinking to provide an additional layer of perspective and insight. Please feel free to comment or discuss better ways to refine any assumptions or calculations used in the case study!