Feb 07, 2011
Tags: Corporate Finance, Financial Modeling, Financial Modelling, Investment Banking, Company Valuation
In the last post we discussed the concept of return on invested capital, how to calculate invested capital and ROIC. In this post we are going to discuss an important consideration in financial modelling, which is future capital investment requirements and how this affects ROIC.
Invested Capital was defined in the last post as the sum of invested debt and invested equity capital, minus cash. These values were derived from the balance sheet of the company we were looking at. This is one method of looking at invested capital but it hides the actual return that a company has earned on its capital base, and can earn in the future.
Let's run through an example which shows a 5 year life-cycle of a company and its return on invested capital:
This is a simple example set of financial statements, but let's run through what is happening with the company.
- The company has purchased some fixed assets (its invested capital) for 2000, financed via a 50/50 mixture of debt and equity. For the sake of example assume this fixed asset is a large building. The large building is depreciated in a straight line over the 5 year period. You should notice that the sum of all the depreciation recorded is -2000, exactly depreciating the fixed assets to 0.
- The company pays its interest on time, and pays out all NPAT in dividends to equity holders. We can see that the company is accumulating cash of 400 per year, this is because the depreciation expense is a non-cash expense that is deductible for tax purposes, so whatever the company depreciates is turned into a cash balance. For simplicity we have assumed the company earns no interest on its cash (just like is the case in a lot of the western world at the moment with 0% government interest rates...).
- Since Invested Capital is Debt + Equity - Cash, we see that the invested capital of the company gradually declines over the 5 years, and as a result the return on invested capital increases to the point where the company is returning more than 100% of invested capital to its capital providers. In other words this company appears to be phenomenally profitable!
- Note that for simplicity we have also assumed no capex over the 5 year period.
So what is wrong with the picture of this company appearing so amazingly profitable? The gap here is that the balance sheet is not a good reflection of the actual invested capital of the company.
In the real world (not accounting world), fixed assets can either decline in value or increase in value over time (or both). In this case the fixed assets are helping this company to generate EBITDA that has grown at a 5% per annum rate since inception of the company in year 0, so in reality the value of that property has probably risen (assuming capitalisation rates are the same or higher - capitalisation rate is basically the earnings yield required for an asset, so 6% capitalisation rate means the value is 1/0.06 x earnings).
So what is the implication of this? The implication for this relates to future investment in fixed assets. Can this company invest in its fixed assets and generate a 100.17% return on invest capital on a sustainable basis? Probably not, otherwise everyone would be doing it and interest rates would be much higher.
So what was the ROIC that the company earned on the investment? To calculate this we will use the Gordon Growth Model with NOPAT set to equal the same as year 5 NOPAT, and a 9% WACC with a 0% terminal growth rate to determine the terminal value:
The IRR from this set of cash flows is 46%, still a phenomenal ROIC given interest rates on debt are 7%, but less lofty than the 100.17% ROIC indicated on the balance sheet in the last year of the financial statements above.
If we were comparing this company to a new company based on ROIC, we need to understand what the current ROIC of this company is. Let's say for example that the fixed assets have grown in line with EBITDA, that is 5% per annum. Their current value = 2000 x (1.05)^5 =2552. The company will no longer be able to claim depreciation expense so next year's NOPAT will equal EBITDA x (1- tax rate) = 972.41 x 0.7 = 680.68. This yields a current ROIC of 680.68/2552 = 26.7%.
So if I were choosing one of two investments, either a new project with a 30% ROIC or potentially the purchase of the example company, I need to compare the 30% ROIC to the 26.7% ROIC, not the 100.17% ROIC calculated from the balance sheet or the 46% ROIC calculated from the IRR.
The moral from this is:
- Financial statements tell you about the past, not the present or future;
- Financial statements reflect values in the accounting world, which can and do differ from the real price world we actually experience;
- Incremental costs are important in assessing the value of a company, not historical costs.
Certain businesses will hide deteriorating ROIC more-so than others. For example, often airlines appear to be generating strong ROIC, but they tend to have capex costs that increase at a rate well above inflation due to tight supply of large aircraft. So the ability of an airline company to re-invest profitably is not accurately reflected in their financial statements, and their current and future ROIC can be very different from their current balance sheet ROIC depending on how long it has been since they re-invested in their fixed assets.
Contributed by Paul Mason