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.


heterocedastico said...

This is realy a great post! Thanks!

In your opinion what is the best way to calculate maintenance capex for the present year and for the long term?


Eddie Bravo said...

Hi Heterocedastico
I am intending on looking at maintenance capex in the next post. So hopefully this will answer your query! Have a happy new year
Eddie Bravo

heterocedastico said...

Eddie, do you have an email?


Gene S. said...

Keeping up on your working capital, being able to predict it with the seasons, especially if you anticipate working capital loans being necessary for your business' financial situation.

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