My point was that it isn't the right formula to use at all for this company and I stand by that comment because I think it's true.
I don't deny that the numbers don't work (but they've been done below, anyway) - my point is that regarding HP, ROIC isn't the right approach.
Using my formula, HP's ROIC in 2023 was 27%. Much lower than 45%, but still way too high.
Let's run some numbers to be clear in this debate:
NOPAT = 100, L-t liab = 500, Equity = 100, Current liab (less lease + s-t debt) = 150, ROIC = 22%
NOPAT = 100, L-t liab = 500, Equity = 0, Current liab = 150, ROIC = 29%
NOPAT = 100, L-t liab = 500, Equity = -100, Current liab = 150, ROIC = 40%
A company that has a shareholders deficit with everything else constant earns the highest ROIC. Since that's not really what the argument is, keep reading.
Suppose debt is what increases so equity decreases:
NOPAT = 100, L-t liab = 500, Equity = 100, Current liab (less lease + debt) = 150, ROIC = 22%
NOPAT = 100, L-t liab = 750, Equity = -150, Current liab = 150, ROIC = 22%
This did occur with Neff - with a proper balance sheet this checks out. (Numbers below reflect Neff Corp after borrowing extensively in the 2010s).
NOPAT = 67, L-t liab = 479.2, Equity = 3, Current liab = 44.5, ROIC = 15%
NOPAT = 69, L-t liab = 721.2, Equity = -206, Current liab = 58.6, ROIC = 15%
So, with Neff, ROIC stayed the same as Spekulatius correctly said.
The question is, is this correct, though? Should ROIC stay the same as a company wipes out their equity through borrowing? Should you somehow adjust equity to a positive value? The numbers work, sure, but is it the optimal method? That's for you to decide.
The situation at HP is even weirder for two reasons - and this is shown by their massive spike in ROIC over the last decade.
1. Working capital decline. (It's already negative, but more noninterest bearing current liab = higher ROIC)
2. Understated intangible assets. (That's my hunch. I can't prove it yet but I think management have been cute.)
The spinoff of HPE was a distraction I think. I'm figuring out exactly how management "divided" the companies.
Combined with the negative equity, especially in tech, you find a "high" ROIC business that actually is misleading to investors.
Other other difference between MCD and PM compared to HP is that they both have an earnings reserve. HP doesn't.
(Obviously, if you run a large working capital deficit, your returns are amplified and your cash flows improve. HP benefits from this, too.)
You can even go to the asset side of the balance sheet and add PP&E (fixed assets), Net working capital + intangibles. At that point, you may as well use ROCE. But even that's "wrong" because I still believe intangibles have been understated. I think there's a similar "problem" in the tobacco industry. PM is the company that comes to mind. I think you have to write up the value of intangible assets here. What's the approach for that? I've never done it in the past.
Truthfully, I'm not entirely sure what the right approach is. ROA seems the most correct but still has its flaws. I still need to think this through a little more but I don't agree that the ROIC is correct, at all, for HP.
for other negative equity businesses. But HP doesn't quite make logical sense.
I think this will probably take more than a day to figure out.
Best,
Harshu Vyas
TLDR- I was wrong to say the negative equity was what HP's ROIC odd. It's a combination of factors. Spekulatius was right. |
