In the last post, we were discussing the denominator of the ROIC ratio, and questions about how to think about invested asset levels, particularly the net fixed assets part. Here is a continuation of that:
Why use book value rather than market value for the calculation of invested capital (the denominator)?
Great question. The idea is to get a sense of how well the business does investing assets to make shareholder returns in the form of income (and we are looking at income from the most recent period, not years ago) with an eye towards the future, so why wouldn’t we use the current market value of those assets rather than book to be consistent? There is a mismatch, right?
Well for starters, for NWC all the assets/liabilities are short-term, so they should be at or close to market anyway. With respect to long-term assets/the fixed plant, in theory the accumulated appreciation should bring its value closer to current value, but we know that depreciation assumptions can be very arbitrary and often useless, and they often ignore the possibility that a productive asset a business owns may have actually gone up in value over time – it’s certainly true of real estate assets. Think about a manufacturing site in Brooklyn that a company once bought to make window treatments – 30 years later it’s a prime condo development site and worth a hell of a lot more than what the company paid, let alone the depreciated value. In Greenblatt’s gum example, if the kid needed to build the next gum factory to support demand for his gum, wouldn’t he pay a market price for that productive asset, rather than the depreciated value of the ancient factory that is already on the company’s balance sheet? Presumably he doesn’t possess some special ability to buy real estate at below market prices, as some kind of sustainable competitive advantage? Surely this would mean lower ROIC, all else equal…
I was very interested in this question when I first learned about ROIC. As mentioned earlier, one can be interested in ROIC to: (1) look at a company’s ability to create value via returns for its shareholders vs its comp set (relative capital productivity), (2) use it to evaluate management’s ability to create value for shareholders, or (3) understand if a company has sustainable competitive advantages that make it a superior investment in absolute terms or put another way, determine if a business is able to dependably creates value in excess of the reproduction cost of its assets. The last part is what I am most interested in as an investor, and that makes me think invested capital should be calculated using something close to current market values. Here are a few things that I have come across that have been useful in thinking about it, and may be useful for you:
Use Gross Invested Capital if this bothers you.
Here is a cut and paste from investopedia on this topic and the link to the page:
Return on Gross Invested Capital (ROGIC) is a measure of how much money a company earns based on its gross invested capital—calculated as net operating profit after tax (NOPAT) divided by gross invested capital. Gross invested capital represents the total capital investment, which is net working capital plus adjusted fixed assets plus accumulated depreciation and amortization. ROGIC is used because it does not increase artificially, as other measures do (e.g., ROIC), from the write-down/accounting depreciation of an asset’s value.
Just Be Consistent In Your Approach
I’m guessing Joel Greenblatt’s response here would be something like “Hey, ROIC is just a ball-park kind of thing for comparison purposes, don’t get so worked up. If you want to use gross assets or pull out certain assets, sure, but just be consistent.”
Be Mindful Of The Old Plant Trap
This concern is a Real Thing, and some people feel strongly about adjusting for this accounting distortion. In particular, the HOLT/CFROI people, and they call it the “Old Plant Trap,” which is borrowed from Fabozzi’s Value-Based Metrics: Foundations & Practice. Here are some excerpts from Beyond Earnings: Applying the HOLT CFROI and Economic Profit Framework pages 60, 61,62 that explain the problem, and how they address it by adjusting invested capital for inflation:
It is important to note net operating profit is stated in current dollar value while net assets are stated at historical cost. This incongruity makes comparison between firms more difficult and ROIC less reliable unless the asset base is restated in current dollar value.
As a business or project gets older, the return on net assets increases, all things being equal. Have the economics changed? No…ROIC increases only because assets depreciate, which decreases the amount of net assets each year….Beware the old plant tramp! It shows up all the time in industries characterized by lumpy investments.
ROIC is highly dependent on reinvestment and depreciation rates….investors are regularly fooled by trying to compare returns on new assets versus old assets…The quickest way to increase returns is to cut capex for a few years. It might kill the business but it will look like the company is improving on paper….”
When I write a post about the CROI methodology, you will see how the inflation adjustment works to address this issue.
Beware The Investment Cycle
Per above, when using ROIC to compare companies, you should generally be thoughtful about where each is in its capital investment cycle – if a company is showing low net fixed assets but is about to embark on a massive investment campaign to replenish its assets, that is going to very much impact future ROIC, and you have to kind of normalize for this if comparing to companies that are in different phases of fixed investment cycles.
This issue goes to the heart of ROIC analysis because it makes us ask, how much is past ROIC performance reflective of future ROIC performance? Accounting aside, the fact is that ultimately a business’ assets must be replaced or updated so that it can continue to generate returns, and if we are using investment numbers for the past that are too low, we will make bad assumptions about returns in the future.
Return On Incremental Invested Capital
This is addressed by the concept of returns on incremental invested capital (ROIIC) which is discussed by Mauboussin in Calculating Return On Invested Capital (page 11) or Return On New Invested Capital (RONIC) in Valuation: Measuring and Managing The Value of Companies, 7th Edition (page 288).
At the end of the day, it’s new investment returns that are the most important thing, and if the past doesn’t inform our assumptions about that, it’s not worth studying. Future post!
Remove Fixed Assets
Finally, if you are interested in ROIC only for purposes of comparing companies, you could strip out fixed assets so that you remove this problem entirely. Of course, this is not useful for thinking about returns in an absolute sense because the resulting % doesn’t take into account all the assets the business is deploying for its returns. Here is an example of a sellside model that includes this metric for Zimmer Biomet (, it’s the return on net operating assets line, and (not surprisingly) it’s a high %:
ZBH 105.69 -1.65 -1.54%
More coming on calculating ROIC.