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.
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:
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.