A Reader’s Question on ROIC and MROIC, Goodwill and Clean Surplus Accounting

S.A. Nelson’s little book, The ABC of Stock Speculation, cites the basic opportunity for manipulation in these words: “The great mistake made by the public is paying attention to prices instead of to values.” What do we mean by paying attention to prices rather than values? Human nature is one of the few constants in an ever-changing world:  “It is only fair to say that the public rarely sees value until it is most markedly demonstrated to them, and the demonstration comes generally at a pretty high price. It is easier for them, as experience shows, to believe a stock is cheap when it is relatively dear, than to believe it is cheap when it is more than cheap.”

A Reader Asks about ROIC and MROIC (Marginal Return on Invested Capital)

I have been thinking about return on capital. My understanding is that one thing Greenblatt is trying to do come with in his Magic Formula is an incremental return on capital – that’s why he excludes things like goodwill. He’s arguing that it’s the return he can get on the assets that actually exist that’s important.

JC: True

I’ve expressed scepticism about this before, arguing that increases in earnings often come through acquisitions, and therefore goodwill was/is a true capital cost (if the company didn’t need to spend money on goodwill, then why did it?).

Well, this got me to thinking – if what you’re really trying to ascertain is a company’s incremental return on capital – then why not CALCULATE an incremental return on capital, rather than some surrogate? The formula is simple enough (and nothing new, I didn’t invent the idea):


There are some nuances, like whether you want to use EBIT figures or net income, adjusting for share issues, and so on. But you could use something like EBIT in the numerator, and total capital in the denominator.

What are your thoughts on this?

JC: You should look at a company both ways. What are the returns on the net tangible assets employed AND what are the incremental returns on capital employed in the business.  We only have a few more chapters in Competition Demystified and then I will begin a long series on valuation-the death march.

For now, you may get some insight here:Dale Wettlaufer on ROIC and MROIC, EconomicModel of ROIC_EVA_WACC and ROIC and the Networking Industry.

You are not the only investor to be skeptical about IGNORING GOODWILL. See page four in this article:Why bad multiples happen to good companies. Cisco (CSCO) CSCO_VL, for example, has a high ROIC–so you will find it on http://www.magicformulainvesting.com/welcome.html but much lower ROC (Return on total capital) due to many acquisitions that were acquired with goodwill. Yes, investors are laying out real dollars, so you need to track the success over time (rolling average of a few years) of those acquisitions.

Question on Clean Surplus Accounting

OK, very interesting John. I’m reading the book Book-on-Buffett-Methods-of-Clean-Surplus . I’ve only got to page 65, but I’m seeing the idea. The author uses a LOT of words to describe a very simple concept.

JC: Agreed. The author says in 230 pages what he could say in 3.

What’s very interesting is that by stuffing a lot of so-called one-off charges through the P&L, a company is able to “juice” its returns for the year, creating an artificially high ROE for subsequent years. Does it mean that clean surplus accounting paints too rosy a picture of a company? The answer is: probably not. With clean surplus accounting, all that “juicing” gets accumulated into the retained earnings of the company, so that in subsequent years, assuming the absence of further exceptional items, returns will actually come out lower. So in effect, clean surplus accounting isn’t being fooled by these non-recurring charges into over-estimating ROE.

The drawback seems to be that you have to go back into the mists of time to find out what the true retained earnings should be, and scrupulously adjust for capital issues, and suchlike. To make matters worse, you need a good set of accounts, which you can probably only get for 5 years. Sites might give you net income, but they wont give you comprehensive income – information which you need to see what’s been shifted around where.

JC: Well, once you are interested, you can always go back at least ten years with the SEC filings.  Also, watching margins, buybacks, prior use of capital allocation can give you a further clue. Also, how clean is their accounting? Track what management says vs. what they do.  You have to put together a mosaic on the company.

Also, what’s you view on goodwill? Should it be treated as a non-recurring charge?

JC: No, because some businesses like Cisco (CSCO) or Seacor (CHK) are making acquisitions as part of their ongoing operations. Better to understand the particular business rather than apply a one-size-fits all approach.

What about exceptionals that seem all-too-frequent? Would you treat them all as non-recurring, or might you assign a proportion as recurring, and a proportion as non-recurring? Maybe you could say a proportion of sales would count as non-recurring, and a proportion as recurring. Maybe you could take a proportion as recurring – say 20% – and the rest non-recurring. You could, of course, argue that over the long term, all exceptional items are recurring to a first order of approximation.

JC: I am a little lost on this question. Can you provide an actual example? In the end, you are trying to get to “normalized” earnings. What is the basic owner’s earnings (cash you can take out of the business without hurting the business in its competitive environment). Many businesses are too tough to figure out what their normalized earnings will be so you walk away. There is a reason why Buffett invests in a chewing gum company (Wrigleys) and not Microsoft. He wants to know where the business will be in ten years. People will still chew gum but will they still increase their use of Microsoft Office?  I am not implying that you not invest in Microsoft–just be ware of the risks in your assumptions.

JC: We will have a long, brutal slog in analyzing how to value growth in a few weeks. You have to know this as an investor, but the real fun is in understanding a business so you can have some confidence in your assumptions.

Thanks for the questions.

7 responses to “A Reader’s Question on ROIC and MROIC, Goodwill and Clean Surplus Accounting

  1. Hi John, I haven’t had much of a chance to process your post properly – the water is filling the bucket up faster than it’s emptying – and I’m still working on that date. Do you think she likes good capital allocators? 😉

    One thing that I did think about lately with regards to the marginal return on capital issue: might we look at ROE (or whatever return you prefer), and factor it in with DCOV (dividend cover). The expected growth rate would then look like this:
    GR = ROE * (1 – 1/DCOV)
    Intuituively, this makes sense. If you have a company like See’s Candy, it has an enormous ROE. However, it has a hard time growing its franchise, and remits all of its earnings to Berkshire. So, in this case, DCOV is 1. This reduces GR to 0, whatever its returns on capital is.

    So if you were to buy See’s today, you would effectively only get a dividend yield (which would purely be a function of negotiated share price), even though the company itself earns fantastic returns on captial.

    Most companies are not See’s, of course, and will give some kind of intermediate return of pure growth and some dividend – but you can see how DCOV combined with ROE is giving you information about the number of opportunity to redeploy capital and the likely return you’ll get.

  2. I wonder if the good reader would be so kind as to summarize his learning on Clean Surplus in the 230 pages he’s reading, into the aforementioned 3 pg of golden material hinted at by the redoubtable Mr. Chew, and then package said material up as a PDF to be distributed to the fine ladies and gentlemen of this establishment at a date hence?

  3. One thing I’ve noticed is that when companies make acquisitions, it is the fashion of the times to restate assets of the acquirees at “fair value”. This means “downwards” (Here’s aparadox to ponder: auditors had happily signed off the accounts of the acquired company as representing a “true and fair view”, most likely for years, and yet the acquiring company views those same assets as massively overstated, Curious, no?).

    Leaving aside my little paradox, the problem here is that for companies persuing acquisitions, it may be that returns on tangible capital are substantially overstated.

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