Paper discussion series - discussion on roic

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    Discussion on ROIC (Return on Invested Capital)

    A draft

    Karnen (a lifetime student)

    In a textbook on Corporate Finance : Theory and Practice (by Pascal Quiry, Maurizio

    Dallocchio, Yann Le fur and Antonio Salvi. UK: John Wiley and Sons, Ltd. 4th Edition. 2014)

    chapter 26 : Value and Corporate Finance, it seems to me that the authors still use ROCE

    compared to WACC. I don't think ROCE is appropriate to use, since it is an accounting term,

    something I believe the authors are quite aware of. ROCE is built on debit side of the balance

    sheet, which carrying "value" (read: cost) is much different from market value (the authors have

    beautifully explained about this difference in one of the chapters). Though we have Debit side =

    Credit side of the balance sheet, but in reality, we do know, with Price-to-Book-Value is not the

    same with 1, then Debit Side not equal with Credit Side. So I believe what the author really want

    to say in that chapter, is ROIC, with the denominator is the market value of the Debt and Equity.

    In practice, it is much easier to determine the Enterprise Value of the company, instead of going

    straight to valuing the Debit side since there are SO MANY STUFFS that we don't see on the

    debit side.







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    Page 2

    Pascal Quiry, Prof. of Finance from HEC (Paris, French)

    I do not agree. It is very important to understand 2 different things: on one side what you ask

    and on the other side what you get. I am pretty sure I will not teach you that you do not always

    get what you ask!. What you ask is a financial conception : the rate of return you are looking for

    ( WACC or cost of equity) determined thanks to the CAPM. What you get is an accounting

    concept : ROCE. Comparing the 2 is a very powerful tool.

    When ROCE > WACC and it is assumed that this situation can last in the future then Value of

    equity > book equity

    When ROCE < WACC and it is assumed that this situation can last in the future then Value of

    equity > book equity

    I am strongly again computing returns on market value for this leads to nowhere. For example,

    you buy a share in a high growth company like L'Oreal, with a P/E ratio of 25. Your return will be

    poor, 4%, and below cost of equity and it has been constantly so for decades as this company

    has always been a fast growing company since its IPO in the 60s. So you never buy a share in

    a company like L'Oreal because its market return is always below its cost of equity. And you

    miss one of the most dazzling stocks ever.

    On the contrary you buy shares in low P/E ratio shares with, as a consequence, have a high

    market return. Not because they are undervalued but because they have low growth prospects.

    Ignacio Velez-Pareja (a finance scholar and consultant, Columbia)

    ROCE and ROIC. Look for difference. To me ROIC refers to D+E (book value).

    Agree! People (perhaps managers and some academics) don't realize that WACC means

    "market" values and Accounting ratios refer to book values. That comparison makes no sense.

    You might correctly think why I say this and yet suggest ROIC to estimate the total risk as said

    in a previous message. Well, notice I am not equating ROIC with total Ku BUT, its standard

    deviation (total risk).


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    Prof. Pascal, referring to ROCE (the debit side of the balance sheet - using book value) instead

    of ROIC (the credit side of the balance sheet - which I suggest it should use the market value).

    However seems to me, he believes that it is always the book value of debit side that we should

    use. That is ROCE. I will get more clarification from him. I am still a big fan for all put on the

    market value to make it all on the same floor across the companies and across time series. Let

    alone...WACC is a market-derived rate...then apple-to-apple requires ROIC to be used instead

    of ROCE. But some authors, as I read their books, they keep using ROCE, which is the net

    working capital + net fixed assets (which all are stated in book value).

    Ignacio Velez-Pareja

    There is lot of definitions and not consistent and are misleading. See for instance

    Capital Employed as shown in the denominator is the sum of shareholders' equity and debt

    liabilities; it can be simplified as (Total Assets Current Liabilities). Instead of using capital

    employed at an arbitrary point in time, analysts and investors often calculate ROCE based on

    Average Capital Employed, which takes the average of opening and closing capital employed

    for the time period."

    Notice that this assumes Current liabilities = Current Assets, but the initial definition is the one I

    use as ROIC. IC = Debt + Equity (book value).

    Capital employed is a fairly convoluted term because it can be used to refer to many different

    financial ratios. Most often capital employed refers to the total assets of a company less all

    current liabilities. This could also be looked at as stockholders' equity less long-term liabilities.

    Both equal the same figure.

    How to Calculate ROCE

    Both the numerator and denominator of the return on capital employed are subject to a variety

    of definitions. The main elements are:


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    Numerator. This is most commonly earnings before interest and taxes, though you can

    also strip out any earnings from investments, in order to focus more clearly on the return

    from operations.

    Denominator. This is total assets minus current liabilities. It is essentially all of

    stockholders' equity plus debt.

    The ROCE formula is:

    (Earnings before Interest and Taxes)/ (Total Assets minus Current Liabilities)

    Just to show you a few cases.

    The general equation for ROIC is as follows:

    (Net Income-Dividends)/Total Capital

    Also known as "return on capital"

    Invested Capital = Total Equity + Total Long Term Debt

    The general formula for calculating ROIC is:

    ROIC = Net Income after Tax Invested Capital

    Invested Capital represents the investment in the company, be it funded through debt or equity,

    that has is being used to generate income. The basic method for arriving at Invested Capital is

    by comparing net income (after tax) with invested capital, illogical, as if I measure the cost of

    debt as Interest/Total Capital. There should be a logical relationship between numerator and


    EBIT ===> Invested Capital

    Net Income ===> Equity

    But, Net Income/ Invested Capital?

    To me, that makes no sense.


    Page 5

    This means that in some work I have said that ROIC is EBIT(1-T)/Invested Capital are wrong

    according to common knowledge. However, as I defined "my" ROIC as EBIT(1-T)/Invested

    Capital , I hope a reader will understand. In this context, what I call ROIC is ROCE.


    The key I guess, is apple-to-apple.

    For example, comparing Net Income to Invested Capital is not apple-to-apple. As you always

    said, don't forget asking "whose cash flows is this?"...Then Net Income should go to Equity...

    If we want to use Invested Capital (either the debit side of the balance sheet or the credit side of

    the balance sheet - the financiers) then apple-to-apple comparison will pick up EBIT (before or

    after tax) as the numerator.

    As I keep reminding people that WACC is the market term (though it is also dependent on the

    free cash flow and later the levered value of the company), comparing WACC to ROIC or ROCE

    which is taken from the book value of the balance sheet, is not an apple-to-apple comparison.

    As we both know, there are so many "assets" that we unfortunately (as the world is regulated by

    accountants), cannot find it though their roles are so critical, such as R&D, internally generated

    intangibles, marketing spend and last but not least, the operating lease that go directly to the

    profit and loss. They all somehow, whether we see or not them on balance sheet, give big

    contribution to the generation of cash flows and earnings.

    ROIC or ROCE should always be a market term, meaning we need to adjust them to the market

    value. However, as many people don't really understand how the valuation is working or maybe

    as they just are short of time, they just jump at taking the book value or net carrying value of the

    balance sheet for the calculation. Market value could be higher or lower than the net book value.

    Bottom line, apple-to-apple....

    Article Source: Email discussions in early March 2015

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