Tuesday, December 25, 2007


Greenblatt's ROIC formula in The Little Book That Beats The Market is
ROIC = EBIT/Net Working Capital + Net Fixed Assets

For the 20-30 stock TLBTBTM portfolio this is a good quick and dirty calculation. But if you run more concentrated portfolios and do single stock selection then I think it may need tweaking.

Firstly, Greenblatt notes in TLBTBTM's epilogue his version of Roic is unsuitable for utilities or financials. Beyond this McKinsey's observations (see last post) on low capital base firms apply.

The next issue with Greenblatt Roic is it assumes EBIT is approximate to FCF, i.e., Depreciation and Amortization are equal to capex. This should be so most of the time but there are cases when it is not.

Some companies also may have different depreciation policies, e.g. DDB versus SLD, which may distort EBIT comparisons and may need adjustment.

Companies where capex is higher than D&A are investing increasing amounts in their business (assuming the line item for D&A is mostly depreciation). By itself, this is neither good nor bad -- it depends on how wisely the firm deploys the money.

Actually, Mr. Greenblatt himself thinks EBITDA - Maintenance capex
may be a more useful metric for pre-tax discretionary free cash flow.

Acquisitions used to grow or run the business may also need to be factored in as capex.

Another issue may also arise when companies utilise capital leases as opposed to operating leases, their 'lease expense' will instead appear as an interest expense lower down the P&L, distorting EBIT. Here one needs to go into the cash flow statement and find the real lease expense and adjust accordingly.

These issues should have a minor impact but they are worth being aware of.

Finally, the denominator of the formula may not account for all capital and assets required in the line of business. Some companies will rely on off-balance sheet arrangements, such as, operating leases, take-or-pay agreements, use of subsidiaries, sales of receivables and so on.

For companies with large amounts of operating leases McKinsey's criticisms of Roic may apply or one could correct the net fixed asset figure. This can be done either via conversion of the operating lease payments to a capital lease or seeing what other similar companies' asset bases are and the cost of those assets.

Sale of receivables without recourse (revealed in the footnotes) will distort net working capital, profits from such sales should be added back into current assets.

Take-or-pay/throughputs. Best to look at similar companies here and see how widespread these funding agreements are. You may want to take the present value of these payments and add them into the company's fixed asset or working capital base.

Perhaps an improved Greenblatt Roic calculation for picking single stocks would be;
EBITDA adjusted for capital leases - (capex + relevant acquisitions)/Net Working Capital + Net Fixed Assets

Where in the denominator
Net working capital = (current assets - liquidity on hand + funds from sale of receivables) - (current liabilities - short term borrowings)


Net fixed assets = tangible fixed assets adjusted for use of operating leases & throughput agreements- construction in progress.

Monday, December 10, 2007

Return On Invested Capital (ROIC) measures the levels generated by each dollar of capital invested in a company's operations and how profitably management is able to allocate capital to generate cash flow over its weighted cost of capital (WACC).

ROIC-WACC spreads are KEY to value creation. Firms whose ROIC exceed their WACC generate positive net cash flow, creating value; while a company whose ROIC equals its WACC neither creates nor destroys value.

Generally, companies with higher ROIC-WACC spreads are more valuable and command higher multiples.

If a company is selling for, or below, book you can be fairly sure it has not earned its WACC in the recent past.

Firms can create value by one of three avenues:
1. Reallocating/improving use of existing capital to increase the spread.
2. Deploying more invested capital into current operations or investing in new projects provided returns generated by either generate marginal ROIC in excess of WACC.
3. Lowering their WACC.


Increasing industrywide and extraordinarily high ROICs are hallmarks of young, strong and growing sectors. In contrast, sequential declines, or marginal ROICs below historical ROIC (barring seasonal factors), may indicate a mature industry where long-term investment opportunities are waning.

Consistently high ROIC-WACC spreads generally equate to the 'moats' that many investors seek. One very rough way of gauging a 'moat' would be to look to see whether a company maintains a high ROIC-WACC spread for several years.

Again, as a rough rule of thumb, WACCs for most U.S. companies range between 9-13%, so ROICs consistently in the mid to high teens allude to something Moat-like and worth digging into.

ROIC solves some of the P/E ratio's pitfalls, particularly, PER fails to illuminate whether firms are producing value, or how much capital firms consume to produce earnings. But like all metrics ROIC has its pitfalls.

First off, you obviously need to monitor the trend. ROIC in the high teens may be great, but less so when its come off a base in the 20% range.

More critically, ROIC can be problematic for companies with very low invested capital bases. E.g., companies that outsource production, like software development firms, and most services firms, like advertising agencies, will have very low invested capital bases.

McKinsey & Co. point out for companies with invested capital below 25% of revenue ROIC may not be a fantastic benchmark as small changes in capital requirements can cause the ROIC to be both very large and volatile from period to period.

Some solutions would be to;
1. Normalize capex over a period to smooth out volatility
2. Or not use ROIC altogether, McKinsey offer an alternative calculation for those interested, in the above link.

It is also not helpful to compare ROIC across industries. In 2004, system software development companies' median invested capital as percentage of revenue was -3% compared to 163% for hotels, resorts and cruise liners, according to McKinsey.

There are two equations used for calculating ROIC that I have seen used most frequently:

1. The standard ROIC formula
Net Operating Profit After Tax/ Average Invested Total Capital

2. The Greenblatt Method
EBIT/Net Working Capital + Net Fixed Assets

I'm going to focus on the second method in my next post as it seems to have captured value investors' attentions recently. Handily, the Greenblatt method is, I think, more intuitive than the traditional method and easier to calculate.

Wednesday, December 5, 2007

Back Again and some stuff to come on ROIC

Sorry for being away for almost six months. Have been studying for the CFA level one, which was quite time consuming.

Anyway, thankfully it is now all over and done with and its december, which means stuff has quitened down and Xmas rolls around... and I now have some more time on my hands to post. I will be posting some stuff on Return On Invested Capital calculations over the next few days....