Clayton Christensen pioneered the fields of management and innovation.
His book, The Innovator’s Dilemma, was called one of the six most important business books written by The Economist. Andy Grove, then the chief executive of Intel, said a year after its publication that it was the most important book he had read in 10 years. In 2011, Forbes called Clayton one of the most influential business theorists of the last 50 years.
Why is Clayton Christensen important for our discussion of return on invested capital, or ROIC? I’ll tell you.
In the June 2014 issue of Harvard Business Review, Christensen, together with Derek van Bever, wrote an article titled The Capitalist’s Dilemma. It was a proposed solution to what was a sluggish US economy sixty months after the 2008 recession ended, producing disappointing growth and job numbers. The argument was that corporations, despite being flush with cash, failed to invest in innovation that would foster growth.
In it, Christensen wrote something important about financial metrics:
Because they were taught to believe that the efficiency of capital was a virtue, financiers began measuring profitability not as dollars, yen, or yuan, but as ratios like RONA (return on net assets), ROIC (return on invested capital), and IRR (internal rate of return). These ratios are simply fractions, comprising a numerator and a denominator, but they gave investors and managers twice the number of levers to pull to improve their measured performance.
To drive RONA or ROIC up, they could generate more profit to add to the numerator, of course. But if that seemed daunting, they could focus on reducing the denominator—outsourcing more, wiping more assets off the balance sheet. Either way, the ratio would improve. Similarly, they could increase IRR either by generating more profit to grow the numerator or by reducing the denominator—which is essentially the time required to get the return. If they invested only in projects that paid off quickly, then IRR would go up.
Why is this important? Because ratios and financial metrics tell us just what they claim to tell us: the return on assets is…the return on assets; the profit margin is…the profit margin; the return on invested capital is…the return on invested capital. The problem is in how those ratios are understood and applied.
For company managers, it’s easy to feel pressured to maximize such returns in the short term leading to underinvestment in future growth. And for investors, it’s today easy to instantly, but mindlessly, look up any of these financial metrics with some online data provider.
Simplistic and easily accessible data points stymie capable people when they don’t understand what surrounds them and why. ROIC is a commonly misunderstood metric. You’ll understand why in a few minutes. Like all ratios, ROIC consists of a numerator and denominator. And when there are levers to be pulled, there are people to be fooled.
This guide covers:
- Definition of ROIC
- The ROIC formula
- Why ROIC is important
- Misconceptions about ROIC
- Calculating ROIC the right way
- Accounting adjustments
- Conclusion
Definition of ROIC
ROIC is a measure of capital efficiency that tells whether the management of a business is deploying its capital intelligently. The easy way to understand it is through Warren Buffett’s $1 test proposed in his 1984 shareholder letter:
We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.
Unrestricted earnings should be retained only where there is a reasonable prospect – backed preferably by historical evidence or, when appropriate by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.
What “generally available to investors” means is the opportunity cost of capital. A business only passes the $1 test if it earns a return on its investments above its cost of capital.
What kinds of investments are we talking about? All kinds of them. All businesses must continuously make capital allocation decisions to maximize returns for shareholders. Whether it’s machinery, equipment, property, securities, or R&D, the business must make comparisons of the returns it can generate before allocating its capital.
To simplify, if a company invests $1,000 in some equipment at the cost of capital of 10%, which in turn generates $70 in after-tax earnings into perpetuity, it would have a market value of $700 ($70/.10). The investment in new equipment would then fail the $1 test since one dollar invested turns into less than one dollar’s worth. Earnings of $120 would have a value of $1200 ($120/.10), passing the $1 test.
ROIC is the aggregate return measure of all the investments the company has made. As a company announces new investments such as capex or acquisitions, the market judges whether those investments add or detract from value. If the company is believed to generate returns over its cost of capital, it’s priced at a premium to book value of capital. If the company continuously makes investments that earn returns below the cost of capital, it destroys value and deserves a discount to book value of capital.
The ROIC formula
ROIC = NOPAT / invested capital
Notice that neither the numerator nor denominator of the formula are standard measures, meaning you won’t find them on any financial statement. You gotta figure them out. This is where fundamental analysis comes into play.
The numerator is net operating income after tax (NOPAT) rather than net income. NOPAT is a company’s potential cash earnings on an unlevered basis. Whether a company is highly levered or free of debt is the same when using NOPAT.
NOPAT is an important figure in finance. It’s the number from which you subtract investments (change in net working capital, net capital expenditures, and net M&A) to estimate free cash flow in a DCF. And it’s the number from which you subtract the absolute cost of capital (capital charge) to calculate economic profit.
The denominator is invested capital. Invested capital can be looked at in two ways which equal out due to double-entry accounting. It’s the net assets required to run the operations. Alternatively, it’s the financing a company’s creditors and shareholders need to supply to fund these net assets. The former is called the operating approach and the latter the financing approach.
Note that invested capital is based on book value rather than market values. Why? The purpose is to calculate the return earned on the capital invested in existing assets and you’re assuming that book values effectively measure these investments. If you were to use the market values, you’d mark up the value of existing assets to reflect the market’s perception of their earning power. In other words, the calculation of ROIC would give an unsurprising result equal to the market’s cost of capital.
Why ROIC is important
Let’s first go through why capital allocation itself is important.
As established, capital allocation involves apportioning resources to generate long-term returns above the cost of capital. You, as an investor, know too well that “generating alpha” is the name of the game. An investment brings you no value unless it exceeds your required rate of return.
All CEOs are capital allocators and therefore investors. All roads to management assessment come from capital allocation. Together with allocating employees to the right positions, allocating capital is the CEO’s task. But the truth is that few companies in the world have excellent capital allocators at the helm. The problem is that how they perform is rarely immediate and obvious.
Most companies are led by skilled managers who can generate decent profits, keeping shareholders happy as long as reinvesting in the business pays off. This applies even to young companies. Early on, these companies have limited options for their cash, usually reinvesting it to fuel growth. But as cash builds up and managers start exploring diversification, mergers, acquisitions, or stock buybacks, their job gets more complex.
Many studies done on M&A come to the same conclusion that most acquisitions destroy value for the acquirer and the ones that do add little value.
Here’s an example of why it matters: If a CEO runs a company for 10 years and keeps 10% of the company’s net worth via earnings each year, they’ll end up deciding how over 60% of the company’s capital is used during their time. This shows that a CEO’s skill in managing money is way more important than their charm for keeping shareholders happy over the long run.
Buffett accentuates the point in his 1987 and 1988 shareholder letters:
The heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics. Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered.
[…] CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers. Charlie and I have frequently observed the consequences of such “help.” On balance, we feel it’s more likely to accentuate the capital-allocation problem than to solve it. In the end, plenty of unintelligent capital allocation takes place in corporate America. (That’s why you hear so much about “restructuring.”)
Three main choices are available for allocating capital, whether raised or retained, are:
Recall Buffett’s $1 test. If a business can deploy its capital and generate a return above its cost of capital, it would avoid using the third option of returning capital to claimholders.
Unless… Many business strategies are based on projections—sometimes stretched far ahead into the future through arcane budgeting methods—and will always to some extent be uncertain. Sometimes, they’re leaps of faith into the unknown.
Occasionally, there’s a capital allocation option that is much more certain than any budgeting. This is when a company’s stock is selling far below its intrinsic value. When businesses with comfortable financial cushions find such an opportunity, pretty much no alternative can benefit shareholders as certainly as buybacks.
Judging capital allocation skills
So how do you evaluate the capital allocation skills of management? The obvious answer is to study past capital allocation choices which is what a big part of the rest of this article is about. But you can’t stop there. For a valuation to be thoughtful, you gotta make judgments about industry structure and competitive advantages to assess how those returns might inflect in the future.
The intelligent investor asks questions like: How’s the capital invested? Might current returns be based on short-term asset stripping or write-offs? Are the returns satisfactory and sustainable? Does it have a moat? Will the competitive environment change in the future and how will that affect future returns?
ROIC and its components do a better job explaining these questions than any other metric. And ROIC is directly interlinked with the stable growth of a company. By stable, I mean the rate by which a company can grow without taking on disproportionally more debt, given an unchanged return. The reason is that growth is never free. To grow, almost every company has to reinvest. The stable reinvestment rate can be stated as:
Reinvestment rate = growth / ROIC
A company earning an ROIC of 10% and wanting to grow 10% has to reinvest 100% of every dollar it earns. It won’t have any excess cash to buy back stock, pay dividends, or acquire other companies. A company that grows by 4% and earns a 10% ROIC would reinvest 40%.
If you think about a DCF, you can now gauge why ROIC becomes the key input in terminal value. For a company that continuously reinvests, the longer you hold it, the more your investment return will converge to ROIC, no matter if you buy the stock at a low or high multiple.
Other metrics of capital efficiency include return on equity (ROE) and return on assets (ROA). But while both are much easier to calculate, they’re inferior measures.
ROE is inferior because it’s subject to financial engineering which can obscure the fundamentals of a business. And while invested capital is more frequently a positive number, there are companies that, due to past losses or buybacks at price book value have negative book values of equity, making ROE meaningless.
Return on assets is inferior due of inconsistencies between the numerator and denominator in the ratio. And it can’t be compared to the cost of capital since that cost is based on the cost of debt and equity.
Misconceptions about ROIC
To properly use ROIC as an assessment of value creation, it’s important to understand its limitations. Here are a few situations people frequently get wrong.
1) They miscalculate it and fail to understand its components.
Here are different estimates of ROIC for PepsiCo, Inc. from data sources pulled online:
No data source computes the same figure. They can’t all be correct.
What does this tell you? There’s not one standardized way to compute an exact NOPAT or exact invested capital. But some are much more correct than others.
Although the ROIC formula is conceptually straightforward, there are a host of practical matters to consider when calculating it (which I will go through in the next section). Standardized data sources, unfortunately, do not do through these considerations. They requires fundamental analysis using good judgment.
This issue requires a little story from Forbes:
Back in the mid-90’s, ROIC-based models such as Economic Value Added (EVA) and Cash Flow Return On Investment (CFROI) were all the rage, with corporate giants such as Coca-Cola (KO), AT&T (T), and Procter & Gamble (PG) linking them to executive compensation and highlighting them in communications with shareholders.
Fierce competition ensued, as a variety of consultants developed and marketed their own shareholder value models, all, at their core, based around the idea that companies need to earn a return on capital above their cost of capital.
That revolution was short-lived. Coca-Cola and AT&T stopped regularly highlighting EVA in filings after 1998. Some of the consulting companies mentioned in the CFO piece no longer exist, such as Finegan & Gressle, while others like The Boston Consulting Group no longer highlight the same metrics.
[…] The lack of resources and technology available at the time required the proponents of these metrics to do many hours of manual work to provide the metrics for the client and its comp group. As a result, the firms wanted to differentiate their models or build barriers to entry around them so that competitors could not piggyback on their original work.
Transparency was not in the consultants’ best interests. If everyone could see the inner workings of their formulas, clients wouldn’t have any incentive to pay big money for their model over a competitor’s. As a result, the various firms guarded their models and would attack a competitor’s formula as a “consultant’s concoction.”
[…] In the intervening years, the burgeoning financial punditry has helped propagate the myth that the market only cares about reported earnings. The rise of the E*Trade baby and amateur investors only furthered the focus on simplistic data points that could be easily calculated and consumed. More sophisticated fundamental research became harder and harder to find.
Today, there is a noticeable gap for the many investors out there that want high-quality fundamental research. Most of the available research out there doesn’t attempt to assess the true drivers of value.
Most analysts don’t dive below the line of the financial statements and into the footnotes. Most don’t do the work required to get a sense of reality about a company’s value creation. To gain a fundamental edge, it’s about doing the job yourself.
2) They fail to account for timing differences.
Some ROIC calculations take the current year’s NOPAT number and divide it by the invested capital from the current year’s end. Others use the average of the invested capital from the prior and current year as the base.
The first way is wrong. The second way is arguably wrong.
Say you buy a stock for $100 at the beginning of a period which rises to $150 by the end of the period. You’d calculate your return as 50%. By this same reasoning, it makes sense to use invested capital at the start of the period for computing ROIC.
Average figures are not entirely wrong since investments that generate income are not fixed during the year. However, this would make more sense if you follow a mid-year convention for income and cash flows.
3) They fail to recognize it’s based on accounting earnings.
Like most of the information worked with in valuation and corporate finance, figures come from accounting statements. ROIC is no different and the ratio is only useful if a company’s accounting gives a fair view of reality.
Some factors may lead you to be skeptical of this assessment. One is the fact that book values leave the return exposed to accounting choices made not only in the current period but choices made over time. For instance, a restructuring charge taken 10 years ago can affect ROIC by “artificially” lowering invested capital for the current period.
Other examples are: hidden expenses, unrecorded goodwill, changes in accounting rules, derivative exposure and valuation assumptions, pension assumptions, employee stock options, minority interests, and more.
In short, both profits reported and assets booked are products of the art of finance. If a company’s accrual accounting is bonkers, ROIC is useless. The intelligent investor will know the practical usefulness (or uselessness) of an ROIC number and make the appropriate adjustments (more on that in a minute).
4) They fail to recognize that the absolute spread between ROIC and the cost of capital doesn’t give a full picture of value creation prospects.
ROIC tells us what it’s supposed to: the return the company made on the capital it invested. It says nothing about how much capital the company can ultimately deploy at the given spread from its cost of capital. But, this is the more important question. Two companies that generate the same positive spread of ROIC to cost of capital will not have the same value if one of them can deploy more capital.
The ultimate outcomes from capital allocation are rarely immediate or obvious. Remember the lesson from Clayton Christensen at the beginning: a company can show a high ROIC today by refusing to make the necessary investments required to maintain its operations and competitive advantage. Or, it can invest sizable capital to innovate and strengthen its future moat, suppressing ROIC today. There’s a distinction in the long run here.
Business schools tend to treat finance and competitive strategy as distinct departments. But the two are interlinked. A thoughtful valuation requires an understanding of industry structure and competitive advantage, and a strategy must pass the $1 test to create value.
Calculating ROIC the right way
Let’s recall the formula:
ROIC = NOPAT / invested capital
I’ll continue with PepsiCo, a company with straightforward financials, as a case study. I’ll do the calculation for the last five fiscal years. Subsequently, I’ll discuss accounting adjustments.
Calculating NOPAT
For NOPAT, you not only need to consider earnings to equity investors (through net income) but also lenders in the form of interest payments because operating income is a pre-debt measure of earnings.
Like invested capital, there are two ways to calculate NOPAT:
1) In the operating approach, you use earnings before interest and taxes (EBIT) and adjust the number for the tax liability.
NOPAT = EBIT (1 – tax rate)
The tax rate used in this formula is not equal to the actual taxes paid if the company has debt. You are acting as if you pay taxes on operating earnings, but in reality, a company gets to subtract interest expenses from taxable income. This is known as the tax shield.
If you were to use actual taxes paid in the calculation of NOPAT, you’d in effect double count the tax benefit from debt; once in the return on capital and again in the cost of capital. You want to avoid doing that.
2) In the financing approach, you can start with net income and then add back interest expenses adjusted for the tax shield. But you’ll also need to remove other non-operating items.
NOPAT = net income + interest expenses (1 – tax rate) – non-operating income (1 – tax rate)
The following table shows PepsiCo’s accounting income statement reformulated to get to NOPAT:
For the past 5 years:
Calculating invested capital
Like with NOPAT, there’s an operating approach and a financing approach to invested capital. One provides insight into the efficiency of asset utilization and the other financing choice. Again, they need to balance. Ideally, invested capital is calculated using both sides of the balance sheet to have a complete overview of what net assets are utilized to run the business and how they’re financed.
The operating approach takes total operating assets subtracted by total operating liabilities. The result is net operating assets (in short, NOA).
Ideally, you want to divide operating assets into current and non-current to gauge the magnitude of operating working capital vs fixed operating assets. Accounts receivable and inventories likely take up the majority here. Non-current operating assets may include property, plant, and equipment (PP&E), intangibles, capitalized lease assets (ROUs), etc.
In the financing approach, you look at how those operating assets are financed. Take equity, add all interest-bearing liabilities, and subtract interest-bearing assets. Interest-bearing liabilites are often not just the straight debt shown on the balance sheet but include capitalized leases (more on that in a moment), deferred taxes, and/or pension liabilities.
The following formulates PepsiCo’s accounting balance sheet to get to invested capital:
The last 5 years:
You can now compute PepsiCo’s ROIC by taking NOPAT for each given year divided by the invested capital figure at the end of the prior year (timing difference t-1).
As you’ve probably noticed, simply rearranging accounting items is not all I did to compose the reformulated income statement and reformulated balance sheet. Other practical issues need to be thought through or adjusted to reflect the economic reality of the business. For example, I’ve created a couple of assets, added back R&D expenses and brand advertising expenses, and replaced them with an amortization schedule. The same thing with operating leases. And then there are some tax adjustments and write-down add-backs.
Let’s go through each of them.
Accounting adjustments
The difference between a good and bad analysis of ROIC is to what extent the company’s accounting earnings and book value are to be trusted. The sensible action is now to take book value as a given but to adjust the numbers to get a better measure of the returns earned by a company as well as the magnitude of investments made.
Equity method investments
Equity method accounting is utilized when a company owns an interest in another company, giving it a significant influence over the investee but not control, typically at 20%-50% ownership of the investee. Equity method investments are not marked-to-market on the balance sheet. Instead, the company’s share of net income/losses of the investee is recorded on its income statement with a corresponding adjustment to its book value, less dividends received.
Equity method investments can be tricky since they’re either classified as operating or financing items depending on their purpose and context. The real question to ask is whether the investment is a necessary component of the company’s core operations (e.g. if the investee is a critical part of the company’s supply chain). If so, the investment should be included in operating assets. If not, the investment should be classified as a financial asset, implicitly assuming it was made with excess cash.
Let’s say that the company recognizes “equity income” every year on its income statement and does so within the “other income/expense” line items (the items typically shown between operating profit and interest items). Let’s also say you determined the investment to be a critical part of the company’s operations and want to include it in NOPAT and net operating assets.
To properly reformulate the income statement, you’d then need to add back the taxes paid on the equity income to get to its EBIT figure. This is important because the equity income figure is an after-tax item. EBIT is a before-tax measure. Then, to subsequently arrive at NOPAT, the taxes paid should be deducted again. The best way to do this is by going to each investee’s annual report to derive the actual taxes paid on the earnings but an alternative is simply using the company’s marginal tax rate.
Note that the income statement and balance sheet must match in convention. If an equity method investment is included in NOPAT, the corresponding asset must be included in net operating assets.
Taxes
Equity method investments are not the only reason why taxes are important here.
A common error when determining NOPAT is adjusting EBIT by the actual taxes paid to calculate NOPAT. NOPAT is a measure that captures the earnings before financing costs. Since NOPAT assumes no leverage, you must remove the tax benefit the company gets by paying debt interest. Again, this is the tax shield.
The same principle applies to other non-operating items such as equity income and unusual operating items netted out, except for goodwill impairments which are non-tax deductible (more on that in a minute).
To calculate NOPAT, you can either use the effective tax rate or the marginal tax rate. Which one depends on whether you’re going to use the figure computed ex-ante (forward-looking bases) or ex-post (backward-looking basis). The effective tax rate is usually used to compute NOPAT. However, using a marginal tax rate will sometimes yield a more robust (albeit understated) value.
R&D capitalization
A company invests in R&D to get an advantage or develop an asset that is expected to provide a multi-year payoff to earnings generation. But that’s not how accountants see it. Per accounting principles, companies must expense most R&D investments in the fiscal year it’s spent since accountants has no reliable way to measure the future benefits of R&D outlays.
To some companies, directly expensing R&D matters little. For others, it can have a huge effect on the perceived profitability and capital invested. In just 2019, Alphabet spent $26bn on R&D, $2.5bn more than it spent on capex. These efforts don’t show up on the balance sheet and depress operating earnings each year.
The solution is to convert historical R&D expenses into a research asset to be amortized over the estimated life of the asset. You have to assume how long it takes for R&D to be converted, on average, into commercial products. Such assumptions vary by company depending on the nature of its research, but a rule of thumb is about 6 years which I used in our capitalization of PepsiCo’s R&D.
Brand advertising capitalization
The same principle that applies to R&D also applies to brand advertising expenses. The amount a company spends on strengthening the value of its franchise is an investment expected to provide multi-year benefits. In just 2019, PepsiCo spent $3bn on advertising expenses.
Again, the solution is to capitalize such investments into a brand asset. It requires making assumptions about amortization and how much of the company’s advertising expenses that are directly spent on brand strengthening. For the capitalization of PepsiCo’s brand advertising expenses, I assumed 50% using an amortization period of 2 years.
Operating lease capitalization
The accounting standards updates, IFRS 16 and ASU 16, changed the accounting landscape for leases and required companies to capitalize virtually all leases from January 1, 2019, and onwards. This was an important step in the right direction but had the unfortunate effect that leases incurred before the effective date need not be restated. So for a lot of companies where operating leases matter much, you find less comparability before and after the effective date. It also means that the financials reported before the effective date provide little insight into the company’s true profitability and level of debt.
Therefore, if a company reported significant operating leases before the new accounting standards and you wish to have a proper time-series overview of the company’s ROIC, these prior leases must be capitalized. The economic rationale is that operating leases must be treated as debt and put on the balance sheet.
Unusual operating items
Some reported income statement items are extraordinary or unrelated to the core operations. They may or may not include items such as asset impairment charges, restructuring costs (if they truly are non-recurring), severance costs, litigation costs, certain pension costs/income, and more. To get a proper perception of what you’re attempting to measure, earnings on a normalized basis, some of these should be ignored or taken out.
Some unusual items might be hidden within operating items such as SG&A and disclosed separately in the footnotes, MD&A, or cash flow statement. For instance, asset writedowns are unusual charges that don’t usually appear on the income statement, instead bundled within other line items. Asset write-downs distort ROIC in two ways: 1) they distort operating costs and 2) they reduce the carrying value of the corresponding assets. If you don’t adjust for writedowns, both NOPAT and invested capital go down artificially down based on a discretionary decision by management, in turn boosting the perceived ROIC in future years since the denominator in the computation will be held down by the new carrying value.
Excess cash
Cash is usually netted out of invested capital since it’s an interest-bearing asset and invested in the business while sitting in the bank. But you argue that some of it is required for operations. Some cash might be earmarked for a young growth company to reach break-even, some might be for short-term capital spending needs, and some for day-to-day operations (like cash sitting in registers).
“Operating cash” can differ widely during different times of the year, in different economic environments, and by business model. And the earlier the company is in its lifecycle, the harder it is to estimate. A young growth company must hold more operating cash than a steady-state firm, all else equal.
A solution is to look at operating cash as a % of revenue. If the company is mature and requires little capital to operate, 1-2%/revenue is a rule of thumb. If it’s a young growth company, 5-10%/revenue may be a better estimate.
For PepsiCo, I took 1%/revenue as operating cash.
Goodwill
Goodwill is generally not included in invested capital on the assumption that it’s paid for growth assets (meaning future investments of the acquired business) and not assets in place. After all, when a company acquires another, goodwill arises as the excess to the amount the acquiree invested in the business.
However, some of the overpayment on net assets may consist of expected synergies in the combination. In that case, you perceive that part of the overpayment as an investment today and you might want to include a % of total goodwill in invested capital.
As a general rule, if you don’t expect the company to do many deals going forward, excluding goodwill provides a better picture of its return on incremental capital. If a company’s business depends on its continued acquisition spree (or if that’s the business model itself), it may make sense to include all of goodwill.
For PepsiCo, I netted out goodwill from invested capital.
Impairments
The question of impairments is related to the question of unusual operating items above. The idea of adding back asset writedowns to invested capital is that investors should hold management’s feet to the fire to deliver returns on all the capital they have allocated in the past.
But, it’s important to use common sense and understand how management uses capital. If management has recently changed or the impaired asset becomes obsolete for the business (e.g. intended to be sold), it makes little sense to “punish” current management into perpetuity by increasing the invested capital base.
If you do decide to add back asset writedowns, do so net of tax savings (excluding goodwill impairments which are non-tax deductible). Note that if you’ve decided to net out all goodwill from invested capital, you can’t add back goodwill impairment charges to invested capital.
For PepsiCo, I added back about $1.5bn of asset write-downs charged net of tax savings in the fiscal year of 2015 which raised the company’s invested capital base in subsequent years.
Discontinued operations
Whether to include discontinued operations (the results of businesses expected to be sold) in the calculation of ROIC depends on the purpose of using the ratio. If you want to look at the company on a backward-looking basis, it makes sense to include discontinued operations. If forward-looking, it should be excluded. The treatment of assets held for sale should be directly tied to the choice made to NOPAT. If income from discontinued operations is included in NOPAT, assets held for sale should remain in invested capital, and vice versa.
Conclusion
The return a company makes on the capital it invests is at the center of corporate finance and how to correctly value a business. The key number in a valuation is not the cost of capital you assign a firm but the return earned on capital that you attribute to it. There’s a significant payoff to measuring it correctly in the first place.
I’ve created a spreadsheet that helps with all of this called the ROIQ model. Get it here.
