Silicon Investor (SI) -- The First Internet Community

STOCKTALK

We've detected that you're using an ad content blocking browser plug-in or feature. Ads provide a critical source of revenue to the continued operation of Silicon Investor. We ask that you disable ad blocking while on Silicon Investor in the best interests of our community. If you are not using an ad blocker but are still receiving this message, make sure your browser's tracking protection is set to the 'standard' level.

Strategies & Market Trends : Value Investing -- Ignore unavailable to you. Want to Upgrade?

To: AsianValueInvestor who wrote (52050)	8/9/2013 6:25:09 PM
From: IndependentValue	1 Recommendation Recommended By Jurgis Bekepuris Respond to of 78673

AsianValueInvestor, Thanks for your response, but I feel I should point out a few corrections to your comments. ROIC with goodwill measures a company's ability to create value after paying for premiums, etc ROIC excluding goodwill measures the true operating competitiveness of the underlying business, without acquisitions. I do not believe you are fully correct with your definitions here. Firstly, ROIC with goodwill measures the return generated by the company (i.e. management) from capital invested in the business, including that capital invested in the past to acquire other companies or other assets, or the deemed value applicable to other intangible assets such as brand, customer relationships or IP; goodwill is NOT always a simple a premium over net assets as you seem to suggest. In the case where the goodwill is a value assigned to commercial intangible asset such as a brand, this amount is often arbitrary and may not necessarily approximate the time and resources “invested” in cultivating that brand or customer relationship, and in this instance, given its arbitrary nature I believe the security analyst can justify omitting this type of goodwill from the ROIC calculation. In the case of goodwill arising from an acquisition, I believe it is logical to include this in ROIC, as it represents an actual historical cost and so is factually capital that has been previously employed in generating consequent income and cash-flow. Secondly, your comment that ROIC excluding goodwill measuring true operating competitiveness without acquisitions is not correct. Remember that goodwill is only one component of an acquisition recorded on a company’s balance sheet. Post-acquisition, there will also be plant and equipment, inventory, assumed liabilities etc. This are part of an acquisition as well as goodwill, and capital has been invested to acquire them. So to say that ROIC excluding goodwill excludes impact of acquisitions as you state is incorrect. Regarding EBIT and tax rates, I acknowledge that tax rates vary from business to business, and obviously from jurisdiction to jurisdiction but tax is a cost of operating any business – to omit this would be to omit a real cost of operating a particular business that you are looking at effectively owning (by virtue of the part-ownership claim you would have from purchasing shares in such a business). I understand your logic on the tax rate point, but I am not sure I agree. When comparing comparable businesses, tax rates will generally be similar anyway. As for non-recurring charges, I agree they should also be considering in determining a company’s earning power, but caution is required here that as an analyst, one does not arbitrarily add back line items of expense that improve earnings in order to justify an investment from an emotional perspective. Your explanation of the denominator to use in ROIC calculations is well thought out, but again I would refer you to my comments above regarding goodwill – I think you need to consider this. Regarding FCF, I usually use operating cash flow minus capex, or minus depreciation charge as a proxy for maintainence capex (this depends on the type of business I am looking at, often both are approximate). Regarding ROUNTA, firstly your point on cash flow manipulation – always perform an earnings quality analysis to assess how much of the FCF is attributable to accounting charges and add-backs and release of working capital for example. Additionally I always cross check this with the cash conversion cycle to understand the cash generation ability. It is a useful exercise and I would suggest you become familiar with this. This will help you to recognise situations similar to the Enron example but which may be more subtle. Regarding an example of ROUNTA, it’s quite straightforward – The numerator = operating cash flow – depreciation (being a proxy for maintenance capex) The denominator = net assets – intangible assets (but not goodwill) + total debt (long-term and short-term). That’s my understanding from reading Buffett, but am open to suggestions from others as its not something he has ever clearly defined. Finally, ROIC is a better measure than ROA or ROE as you state (unless of course a business is financed solely by equity), but this is really because true value of a business is the Enterprise value, something which is usually mis-understood by, and confuses many investors – perhaps because of a focus on ultimately arriving at the equity value to determine purchase price. I have not read the McKinsey book – I’ve heard mixed reviews, but intend to check it out. Hope you found this post helpful, Independent Value.