Tuesday, 30 May 2017

Alternative Measures of Return on Capital

The primary measure of return on capital is return on invested capital (ROIC).

ROIC = net operating profit less adjusted taxes (NOPLAT) divided by invested capital.

ROIC correctly reflects return on capital in most cases, but special circumstances require alternative measures.

Intangible assets

More specifically, investments in intangible assets are expensed, which can introduce a negative bias in ROIC and lead managers to make incorrect decisions concerning how to create value.

Three issues to focus on handling such complexities

1.   When does ROIC accurately reflect the true economic return on capital?

  • When does a more complex measure, such as cash flow return on investment (CFROI) make sense?

2.  How should one deal with investments in R&D and marketing and sales that are expensed when they are incurred?

  • Creating pro forma financial statements that capitalize these expenses can provide more insight into the underlying economics of a business.

3.  How should one analyze businesses with very low capital requirements?

  • Here it is recommended to use economic profit, or economic profit scaled by revenues, to measure return on capital.

Investments in R&D and other intangibles should be capitalized

Investments in R&D and other intangibles should be capitalized for three reasons:

  • to represent historical investment more accurately
  • to prevent manipulation of short-term earnings, and 
  • to improve performance assessments of long-term investments.

These change only the perceptions of performance, however, and will not change the value of the firm.
Since free cash flow (FCF) includes both operating expenses and investment expenditures, capitalizing an expense will not affect FCF.

The process for capitalizing R&D

The process for capitalizing R&D has three steps:

  • build and amortize the R&D asset using an appropriate asset life,
  • make the appropriate upward adjustment on invested capital, and,
  • make the appropriate upward adjustment on NOPLAT.

These adjustments can be applied to other expenses, such as an expansion of distribution routes.

Drawbacks of such adjustments

A couple of drawbacks of making too many such adjustments are

  • the increased ability to manipulate short-term performance and 
  • the incentives for managers not to recognize when to write down an asset created from a capitalized expense.

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