The Investment Checklist
Page 16
Determining Whether the Debt Interest Rate Is Fixed or Variable
Determine if the interest rate on the debt is fixed or based on variable rates, such as LIBOR plus 5 percent (LIBOR is the London Interbank Offered Rate). You will find this information in the financial statement footnotes under the note titled Debt. If the interest rates are fixed, then you will be better able to assess the impact of debt financing. If interest rates are variable, you must allow for the possibility that interest rates may increase or decrease, adding uncertainty to your projections.
Determining the Debt-Maturity Schedule
Refinancing debt represents risk for a business. It is important for you to determine when debt is coming due. You can find the dates when debt is due in the notes to the financial statements under the Debt footnote. For example, a business may have issued debt when interest rates were low. If interest rates rose during that period, and the business intends to refinance the debt instead of pay it off, it will have to pay a higher interest rate which will decrease the earnings of the business.
Other constraints can also limit the availability of credit. Many businesses in 2008 were unable to refinance their debt because the credit markets dried up.
Evaluating Loan Covenants
To understand if a business is financially strained, evaluate its loan covenants and determine if the business is nearing the limits of the loan covenants set by its lenders. Loan covenants are the terms of the loan that the lender requires, and they serve to protect the lender. Loan covenants define default limits and legal remedies available, which give a lender an early start before bankruptcy so that the lender still has time to negotiate a solution. Most bond indentures and credit agreements restrict corporate actions that would impair liquidity in any way by setting minimum ratios that a business may not exceed. For example the covenant might state that the current ratio (which is current assets divided by current liabilities) cannot be below 1.1.
You can usually find information on loan covenants in the 10-K report or other financial filings. If the business is nearing the limits of its loan covenants, this is an indicator that it is financially strained. However, being in good shape with respect to loan covenants is no guarantee of solvency; management is sometimes able to stretch the definition of covenants to present a better financial picture than really exists.
Determining Whether the Business Has Recourse or Non-Recourse Debt
The most benign form of debt is non-recourse debt, which is debt that is secured by a particular asset and not by the overall business. In a non-recourse situation, if the business defaults on a loan backed by a certain property, then it has the right to turn over the property to the lender, without further losses, in exchange for the forgiveness of the loan.
For example, real estate firm Vornado Realty Trust (among the largest U.S. commercial landlords), was able to simply turn over its ownership of some very large properties when it was unwilling to continue to make debt payments on an unprofitable venture. It turned over its ownership of the second-largest furniture showroom owner and operator in the United States to the special servicer overseeing the mortgage. Vornado had $217.8 million in non-recourse debt associated with the purchases of many properties in North Carolina, such as the Market Square complex, where tens of thousands of buyers come to buy from home furnishings manufacturers and wholesalers. Vornado was able to walk away from the debt because it was non-recourse debt, or debt that is secured only by the individual property.10
26. What is the return on invested capital for the business?
Return on invested capital (ROIC) is the profit a business generates relative to the amount of money invested in the business. It shows you how well a business is using its assets. The more profit that comes out relative to the amount of investment required, the better the business. It is calculated by taking income and dividing by the investment used to generate that income. Here are two rules of thumb regarding ROIC:
1. A business with a ROIC below 5 percent is typically considered a low-quality business, unless it is developing a competitive advantage.
2. In contrast, a business that generates a ROIC in excess of 10 percent is a high-quality business.
The average ROIC varies from industry to industry and ranges from negative to more than 50 percent; here are some examples of high-end, mid-range, and low-end ROIC industries:
At the high end, with ROIC typically greater than 20 percent, are industries such as software firms, soft drinks, pharmaceuticals, distilled spirits, luxury products, and medical instruments.
Industries with ROIC of 10 to 20 percent include hotels, packaged foods, grocery stores, drug stores, and book publishing.
On the low end, with ROIC from negative to 5 percent, are industries such as airlines.11
Why It’s Important for You to Calculate ROIC
Suppose you are analyzing two different businesses. The first one earns $100,000 in net income from $10 million in sales, and the second earns $500,000 in net income from $5 million in sales. The first business generates a 1 percent net profit margin, while the second business generates a 10 percent net profit margin. At first glance, which one would you prefer to invest in? Based on this information alone, most investors would prefer the business that earns a higher net profit margin.
However, to better answer this question, you must take one more step. You need to determine what level of investment or assets were required to generate these earnings.
Let’s say in the first business, it takes $1 million in capital to earn $100,000, and in the second business, it takes $10 million in capital to earn $500,000. The return on capital of the first business is 10 percent ($100,000/$1,000,000), while the second business is 5 percent ($500,000/$10,000,000). After considering ROIC, you can see that the first business is a higher-quality business because it requires less capital to generate the same level of profits.
The reason for this is that the higher the ROIC, the more a business is able to earn. Say you buy a business that has $100 in capital and it earns a 5 percent ROIC. What are the earnings of the business? $5 is the correct answer. Now say the business can earn an 80 percent ROIC. What are the earnings of this business? $80 is the correct answer. A business with a high ROIC will deliver more wealth to its shareholders over the long term from higher earnings. Ideally, you want to own a business that over an extended period of time can reinvest excess earnings at high ROIC.
For example, at oil and gas business EOG Resources, Inc., the ROIC has been 20 percent on average since 2000 under the stewardship of CEO Mark Papa. As a result, the book value per share increased from $4.12 per share on December 31, 1999, to $40 per share at December 31, 2009. This caused the stock price to increase from $7.75 per share at January 1, 2000, to $97.77 per share at December 31, 2009, a 1,161 percent increase, not including dividends that would further enhance returns. Furthermore, the stock price increase was not a result of EOG’s stock simply being bid up under pricey market conditions; the price in this case was driven up by earnings, as EOG essentially maintained the same P/E multiple during this entire period.12
It is important for you to calculate ROIC because ultimately the value of a business is based on the returns a business is able to achieve on its invested capital. ROIC also turns out to be a fairly good predictor of stock return over the long haul. In other words, if you pay fair value for the stock and hold it five years, odds are that if ROIC is 5 percent, then your return will be similar.
You must place ROIC for a business in context with the price you pay for the stock, as the price you pay determines your rate of return. If you pay too high a price for a stock such as a high multiple of book value, then a high ROIC will not help you earn a satisfactory return on your investment. You must remember that ROIC calculations are the return earned by the business, instead of the return realized on your stock cost basis. Since your return is based on what you pay for the stock, make sure you can benefit from high ROIC by paying a low price for a stock.
> Methods of Calculating ROIC
The basic method for calculating ROIC is to take income and divide by the investment used to generate that income. There are a number of different ways to calculate ROIC, and no one method is universally accepted. You can calculate ROIC with goodwill, without goodwill, using gross assets, or net assets. You need to adapt the calculation to the type of business you are analyzing. The pros and cons of each method are highlighted below.
The Basic Equation
Let’s first start with the basic equation for ROIC:
Invested capital = total assets
− excess cash
+/− accumulated amortization and depreciation
+/− goodwill or other intangible assets
+ off-balance sheet items
− non-interest bearing current liabilities
Calculate the Numerator
First, isolate the earnings from the operations of the business by removing interest income, taxes, and interest expense:
Remove interest income from cash balances because it is not generated by the core operations of the business.
Exclude taxes because you need to isolate the effects of differences in tax rates, tax loss carry-forwards, or any other forms of tax management.
Exclude interest expense to remove the effects of financing decisions, which vary across businesses and industries.
Also consider subtracting non-recurring items, such as restructuring and impairment charges and amortization charges of intangibles from pre-tax earnings.
Calculate the Denominator
Next, you need to determine which assets should be included, what liabilities should be deducted, and how the assets should be valued when determining the investment base. Ideally, you want to determine how much investment is needed to operate the business day to day. You will have to make several adjustments before calculating the investment base, such as removing excess cash, deciding whether to use gross or net assets, including or excluding goodwill, removing current liabilities, and including off-balance sheet assets and liabilities such as accounts receivable that have been securitized, pension liabilities, and capitalized operating leases.
Be sure to use average amounts for the investment base instead of relying on one specific quarter. For example, if you are evaluating a retail business and you use the end of first quarter numbers, these will be unusually low as the retailer typically has sold off most of its inventory. As a result, the ROIC figures you calculate would be unusually high and misleading.
Let’s now review the pros and cons of adjusting each line item for the investment base:
Remove Excess Cash
You need to remove excess cash that is not needed in the operation of the business so you can better understand the ROIC the core business is generating. Excess cash is any cash that is not needed to operate the day-to-day activities of the business.
For example, at discount retailer 99 Cent Only Stores, ROIC averaged 20 percent from 1995 to 1999, but then it began to drop as the cash balance increased. Many analysts were concerned about the drop and believed it was due to deteriorating business conditions, when in fact, it was dropping because of the excess cash on the balance sheet. By removing excess cash, you will understand the ROIC being generated by the operations of the business. This is often referred to as the return on operational capital. In the case of 99 Cent Only Stores, the ROIC excluding cash was much higher than the ROIC including cash, as shown in Table 5.3.
Table 5.3 99 Cent Only Stores Return on Invested Capital (ROIC)
Source: Time Value of Money, LP internal research and Standard & Poor’s Capital IQ.
Include Property, Plant, and Equipment Costs
You must include the purchase of fixed assets necessary to operate the business, such as real estate, plant, and equipment. You need to determine whether to use the gross book value of these assets or the depreciated, net book value of these assets:
Gross book value takes the historical or acquisition cost of assets without deducting accumulated depreciation or amortization.
Net book value is the value if you remove accumulated depreciation. Because the net book value of an asset is less each year, this causes ROIC to increase each year. This results in a lower rate of return during the early stages of an investment and higher rates of return in later stages, as the asset base decreases.
Let’s look at an example. If a business is depreciating its asset base and earning the same amount of income, then ROIC will naturally increase because the denominator is decreasing. Take an asset with a book value of $200,000 and assume that for the next five years, the business depreciates it by $30,000 each year. If the business generates $10,000 in earnings for the next five years, the ROIC would increase from 6 percent at the end of the first year ($10,000 divided by $200,000 minus $30,000) to 20 percent ($10,000 divided by $200,000 minus $150,000) by the end of the fifth year. Therefore, the same asset generates an increasing ROIC as it gets older. Table 5.4 is a chart showing these amounts (in thousands).
Table 5.4 Effect of Depreciation on ROIC
To counteract this effect, you might want to consider using gross assets by adding back accumulated depreciation. This way, the investment base is not affected by depreciation or write-downs of assets.
Most investors do end up using net book value. The argument for using net assets rather than gross assets is that depreciating assets are offset by maintenance and repair costs, which rise as equipment gets older, thus tending to offset the reduction, if any, in the asset base.
Include or Exclude Intangibles or Goodwill
When calculating the investment base, you may want to remove goodwill or other intangibles, which are not assets that the business must continue to replenish. By removing goodwill, you can more easily see improvements in tangible returns. On the other hand, realize that if you exclude goodwill from your calculations, it may mask the fact that management has overpaid for acquisitions, making the return on capital seem higher than it really is.
There are a few situations where it might be prudent to include goodwill or intangibles, such as when you are analyzing a media business that must buy television rights. These television rights are reflected on the balance sheet as intangibles but are a necessary investment for the business to operate.
Include Off-Balance-Sheet Liabilities
You should add off-balance sheet liabilities to the investment base when calculating ROIC because these are contractual obligations that are similar to debt. These liabilities include operating leases, underfunded pension plans, or securitized accounts receivable.
Operating Leases
An operating lease is the rent a business contractually owes, and it’s not included on the balance sheet, whereas a capital lease is shown as an asset and liability on the balance sheet. You can find operating leases in the notes to the financial statements, and you can either discount the future operating lease obligations using a discount rate or multiply one year’s rent by a multiplier rule of thumb, such as seven.
For example, at CVS Caremark, a pharmacy services company, the Notes section of the 2009 10-K summarizes significant contractual obligations. The total obligation for operating leases are $26.9 billion which is significantly higher than the long-term debt on the balance sheet which totals $8.8 billion at the end of 2009. Thus, off-balance sheet obligations represent a large percentage of total liabilities. If you use off-balance sheet items, such as converting operating leases to capitalized leases, make sure you make the proper adjustments to the numerator. For example, if you are adding off-balance sheet operating leases, you must add rent expense to the numerator (to income) so you avoid double counting.
Underfunded Pension Plans
An underfunded pension plan is a liability because the business must use its cash to make up for the funding shortfall. For example, at Raytheon, a defense technology business, the funded status of the pension plan for 2009, which is shown under the heading of “Net amount recognized on the balanc
e sheets” was a deficit of $4.6 billion. You must include this deficit when calculating the total contractual obligations of a business.
Accounts Receivable
Accounts receivable that are removed from the balance sheet when they are securitized and sold to other investors at a discount should also be added back.
Remove Non-Interest-Bearing Current Liabilities
Remove short-term liabilities, such as accounts payable, compensation and benefits, other accrued items, advance payments, unearned income, and non-current deferred income taxes from the investment base. A payable is effectively an interest-free loan where the business does not have to lay out any money and therefore should be removed from the investment base.
Evaluating a Company’s Ability to Reinvest Excess Earnings
Avoid jumping to the conclusion that one business is better than another business just because it has a higher ROIC. What counts is the ability of a business to reinvest its excess earnings at a high ROIC, which is what creates future value. You need to determine the percentage of excess cash flows that the business can reinvest and whether the ROIC on new investments will be the same.
For example, lubricant manufacturer WD-40 generates a high amount of free-cash flows, which it is unable to reinvest in the business. The reason it can’t reinvest very much capital back into the business is because WD-40 does not have many growth opportunities. Therefore, the company pays out the majority of its free-cash flows as a dividend. If it were able to instead reinvest these excess free-cash flows at its ROIC of 15 percent, then the value of the business would increase significantly due to the effects of compounding.