A little back and forth between Nate Tobik and I about a company I have been analyzing resulted in Nate directing me to a post he had written on an ROIC metric he likes to use. After reading the post, I liked it enough myself that I want to copy the metric, composition and reasoning to my blog with this post so I have it for future reference.
This ROIC metric was developed by Ken Hackel and is presented in his book Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making. It seeks to measure cash returns on invested capital. The formula is as follows:
Cash flow-based ROIC = (FCF – Net Interest Income) / (Equity + Interest Bearing Debt + Present Value Of Leases – Cash & Marketable Securities)
The “footnotes” to this equation are:
- Intangibles are included because they represent real cash outlays used to purchase cash-producing assets
- IBD is included because it serves to help acquire cash-producing assets as well
- PV of operating leases because these leases are essentially debt that helps produce a cash return for the business; excluding them would unfairly boost ROIC and distort return comparisons between companies that lease property versus buy it outright
- FCF includes the payment of cash taxes and the elimination of other non-cash accruals
There’s more information on this metric and a fuller discussion of its benefits and drawbacks at Nate’s original post.