GUIDANCE FOR CALCULATING RETURN ON INVESTED CAPITAL (ROIC) FOR REAL SECTOR OPERATIONS (DRAFT) Earning a return on invested capital (ROIC) greater than weighted average cost of capital (WACC), and growth are the two primary value drivers for companies. High returns and growth create value by driving high cash flows. ROIC is the return earned on the total capital invested in the business whether it is debt or equity. The most important principle to calculating ROIC is to define the numerator and denominator consistently - if an asset is included in invested capital, the income related to that asset should be included in NOPLAT. Annual Return on Invested Capital (ROIC) = Net operating profits less adjusted taxes Invested Capital NOPLAT: Net operating profits less adjusted taxes (NOPLAT) represents the profits generated from the company’s core operations after subtracting the income taxes related to the core operations: NOPLAT = (Earnings before interest and taxes1 + amortization] – cash taxes Where: Cash taxes = operating taxes – increase in deferred taxes = (reported taxes paid + tax shield from interest expense – taxes paid on non- operating income) – increase in deferred taxes NOPLAT can also be calculated starting with net income: NOPLAT = Net income + increase in deferred taxes + goodwill amortization + after-tax interest expense – after-tax non-operating income – after-tax interest income2 Invested capital: Invested capital should typically be calculated as the average of the beginning-of-period and the end-of-period invested capital. It is also permissible to use only the beginning-of-period invested capital, in which case the calculation is closer to a discounted-cash-flow (DCF) calculation used for the life-of-project ROIC (see below). Invested capital = Total funds invested in the operations of the business = Operating working capital + net property, plant & equipment + net other assets (net of noncurrent, non-interest bearing liabilities) Where: 1 However, depreciation should be subtracted. 2 Deferred taxes stem from the difference between financial accounting and tax accounting. Investors expect to also receive a return on them. Goodwill does not really "depreciate"; it is mainly a tax treatment. After-tax non-operating income usually does not come from the operating performance of the company, and is thus excluded to better gauge the company's operating performance. After-tax interest income usually does not come from the operating performance of the company either, and is thus excluded. Operating working capital = operating current assets - non-interest-bearing current liabilities Net PP&E = book value of the company’s fixed assets3 Invested capital can also be calculated starting with total assets: Invested capital = Total assets - non-interest bearing current liabilities - goodwill – non-operating investments, excess cash and marketable securities – other liabilities4 In cases where all the adjustments are small, it is permissible to use the following simplified proxy for ROIC: proxy: ROIC = Net income + after-tax interest expenses Total assets - non-interest bearing liabilities More advanced adjustments to consider: - Operating leases: If material, they should be treated as if they were capitalized. First, reclassify the implied interest expense portion of the lease payments from operating expense to interest expense and add it back to EBITA. Second, add the implied principal amount of operating leases to invested capital. Calculation of WACC will need to be adjusted too by treating the operating leases as additional debt. - Pensions: For unfunded or under-funded pension plans where the liability is recorded in the financial statements, treat the liability the same as interest-bearing debt in calculating invested capital and the cost of capital. For NOPLAT, estimate the implied interest expense on the liability for the year and reclassify a portion of operating expenses equal to this amount as interest expense. - Inflation effects: ROIC can be distorted by inflation especially in high inflation environments, therefore adjustments may be necessary. LIFE-OF-PROJECT ROIC: ROIC is typically an annual measure (i.e. the "annual ROIC"). However, it is also possible to calculate a "life-of-project" ROIC, which amounts essentially to an FRR calculated on the company as a whole. This measure can be used to assess company performance over a defined period (e.g. as projection at appraisal, and as a re-assessment prior to closure). The recommended life-of-project RIOC measure is the internal rate of return for the following cash flow stream: Years 0 1 to T T - Initial invested capital + NOPLAT + Final invested capital - Change in invested capital5 3 Where the book value does not appropriately reflect the value of the underlying assets (e.g. in high inflationary environments) and the assets could be sold for other uses, market values may be used. However, in such cases NOPLAT should also be adjusted to reflect the appreciation of the assets (e.g. the depreciation charge). 4 ROIC excluding goodwill is a better indicator of operating performance and should be standard practice. However, ROIC including goodwill can provide an additional measure assessing how well the company is using investors' funds (e.g. in particular following an acquisition). Non-operating investments, excess cash and marketable securities are not directly related to the company's operations, and returns are also not taken into account in NOPLAT. Other liabilities are those liabilities that are not directly related to the company's operations; their costs are also not taken into account in NOPLAT. 5 Change in invested capital is also equal to change in working capital minus gross investment in PP&E. NOPLAT minus change in invested capital (also called "net investment") is also called free cash flow, and is equivalent to gross cash flow minus gross investment. Non-operating cash flows are explicitly excluded from this calculation. However, note that they do affect the value of the company and one should therefore exercise extreme caution in excluding cash flows as "non-operating". Other adjustments: Further refinements of the calculation may be needed (e.g. for foreign exchange gains or losses, for pension plan funding, etc.). Please consult a standard finance textbook for additional guidance (e.g. Koller, Goedhart, and Wessels: Valuation - Measuring and Managing the Value of Companies, or its earlier versions by Copeland, Murrin and Koller).