<SPECIAL FEATURE>
April 20, 1999
True Performance
By
In the first two parts of this series, we looked at setting up the balance sheet to assess return on invested capital. We now look at the return part of the equation. Next: A Case of Declining ROIC
</SPECIAL FEATURE>
As pointed out in part two, we want to measure the income the company generates before considering what capital costs. In this way, we are looking at the pure earnings power of a corporation before taking into account the decisions that were made to finance the business. For the purposes of our example, here is the income statement we are working with:
Revenues...$1,875
Cost of Goods Sold...$1,200
Gross Profit...$675
Operating Expenses...$298.42
Operating Profit...$376.58
Net Interest Expense...$203.50
Pre-tax income...$173.08
Tax Expenses...$60.58
Net Income...$112.50
Compared to the adjustments that need to be made to the balance sheet, this is the easy part. The return the company is generating from operations is fully taxed operating income. To calculate this, we tax the company's operating income at a standard, statutory rate. In the U.S., the standard is around 35%. For companies with international operations, this is going to be a few points lower. So, the return from operations for the above company is equal to: Operating income minus tax [operating income x 35%]. Another way to express this is operating income multiplied by [1 minus the tax rate]. The simplest way to express that then is operating income x 65%, or 0.65.
The tax component is something that no business can escape fully, although it can shield its operating profits with debt. We want to look at the earnings power of the company and not the efficiency of its tax planning. In assigning a standard tax rate across enterprises, we can judge the operating efficiency of capital without biases on the industry in which the capital is employed. Whether or not we tax operating income, the comparisons across industries will be consistent. The goal is to look at fully taxed operating income. So, in this example, operating income is $376.58 and fully taxed operating income is equal to 65% of that [1 - tax rate], which is $244.78. On a base of $2,600 in invested capital, the company's ROIC is then $244.78 divided by $2,600, or 9.4%.
In short, the formula for ROIC is:
After-tax operating earnings divided by [total assets minus non-interest-bearing current liabilities]
There are other ways to look at ROIC, though. Some people would modify the denominator in the above equation by deducting goodwill from total assets and non interest-bearing current liabilities. This is because goodwill is an intangible asset arising from the purchase of another company at a price higher than the acquired company's appraised net asset value. (Appraised net asset value is usually in the neighborhood of book value). The company's operating managers don't have use of this asset, so a company with goodwill is going to look less productive on an operating basis than a company without goodwill. Therefore, when we want to look at a company's operating ROIC, we back goodwill out of the ROIC equation, as intangible assets are financial capital, not operating capital.
On the same topic, we always want to back amortization of goodwill out of operating expenses. Since goodwill amortization (amortize literally means "to bring towards death") schedules can differ so much between companies and since this is a non-cash expense that is based on an accounting choice that is arbitrary (inside of statutorily permissible periods not exceeding 40 years), we don't count this is an operating expense. Again, this allows an investor to look at a company's operating performance before taking into account distortions to the cash return a company is generating.
In fact, cash-on-cash returns are what we're looking for in calculating ROIC. We're trying to look past distortions to return on capital that are borne of accounting conventions. Accounting is a rules-based system that allows for a number of choices that can be made by financial managers and approved by auditing firms that nonetheless distort the true economic earnings of a company. Cendant <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CD)") else Response.Write("(NYSE: CD)") end if %>, for instance, was able to select a number of accounting policies that increased reported earnings, but analysts focusing on the company's return on invested capital rather than just earnings growth would have had a more useful metric for judging the company's economic profitability. That's because those expenses that were capitalized rather than run immediately through the income statement would have shown up in the ROIC ratio as a larger amount of capital rather than a smaller amount of after-tax operating income. Either way, an analyst can pay less attention to the accounting choices made to increase reported earnings and pay better attention to the company's cash-on-cash returns.