Adjusted average roic

What Is Adjusted Average ROIC?

Adjusted Average Return on Invested Capital (Adjusted Average ROIC) is a financial ratio that measures a company's ability to generate profit from all the capital it has invested in its operations, with specific modifications made to both the numerator (profit) and denominator (invested capital) to provide a more accurate and comparable view of operational efficiency. This metric belongs to the broader category of corporate finance and is a more refined version of the standard Return on Invested Capital (ROIC). While standard ROIC provides a valuable snapshot, Adjusted Average ROIC aims to overcome certain accounting limitations or industry-specific nuances by making adjustments, for instance, by capitalizing research and development (R&D) expenses or removing non-operating assets from the invested capital base. The inclusion of "average" in the name typically refers to using an average of invested capital over a period (e.g., beginning and ending balances) to better match the flow of profit generated over that same period.

History and Origin

The concept of Return on Invested Capital (ROIC) gained prominence as analysts and investors sought a more comprehensive measure of profitability than traditional ratios like Return on Equity (ROE) or Return on Assets (ROA). ROIC distinguishes itself by considering the return generated from capital provided by both debt and equity holders, effectively looking at the entire capital structure. The "adjusted" aspect of Adjusted Average ROIC evolved due to recognized limitations in standard accounting practices that can obscure a company's true economic performance. For instance, treating significant long-term investments like research and development (R&D) or advertising as immediate expenses on the income statement, rather than as investments that build future value, can depress reported profits and distort invested capital.³² Pioneering work by academics and financial practitioners highlighted these issues, leading to methodologies for capitalizing such intangible investments to provide a more accurate picture of a company's capital base and the returns it generates.³¹ These adjustments aim to bring financial statements closer to economic reality, helping users understand the true return on capital employed over time.

Key Takeaways

• Adjusted Average ROIC refines the standard ROIC calculation to provide a more accurate measure of a company's operational profitability relative to its true invested capital.
• Adjustments often include capitalizing certain operating expenses (like R&D or advertising) that are considered long-term investments, and excluding non-operating assets from invested capital.
• A higher Adjusted Average ROIC generally indicates more efficient capital allocation and stronger operational efficiency, suggesting a company is effectively using its resources to generate profits.
• Comparing Adjusted Average ROIC to a company's Weighted Average Cost of Capital (WACC) helps determine if it is creating or destroying shareholder value.
• This metric is particularly useful for long-term investors and financial analysts assessing a company's sustainable competitive advantages.

Formula and Calculation

The fundamental formula for Return on Invested Capital (ROIC) is Net Operating Profit After Tax (NOPAT) divided by Invested Capital. For Adjusted Average ROIC, the core concept remains, but specific modifications are applied to both components.

The general formula is:

Where:

• Adjusted NOPAT (Net Operating Profit After Tax): This is typically calculated as Operating Income multiplied by (1 - Tax Rate), but with adjustments.³⁰ Common adjustments include adding back the after-tax portion of expenses that are effectively long-term investments, such as R&D or significant marketing expenses, which are often expensed in accounting but build future value.²⁹

  $$\text{NOPAT} = \text{Operating Income} \times (1 - \text{Tax Rate})$$

  Adjustments to NOPAT might involve:

  • Adding back capitalized R&D expenses (after tax).
  • Adding back capitalized operating lease expenses (after tax).

• Average Adjusted Invested Capital: This represents the total capital employed by the company to generate its operating profits. It typically includes total debt and total equity, but with critical adjustments.²⁸ The "average" component means taking the average of the beginning and ending period values of invested capital to better reflect the capital base over which the NOPAT was generated.

  $$\text{Invested Capital} = \text{Total Debt} + \text{Total Equity} - \text{Excess Cash} - \text{Non-operating Assets}$$

  Adjustments to Invested Capital might involve:

  • Adding back capitalized R&D assets.
  • Adding back capitalized operating lease assets.
  • Subtracting excess cash (cash not needed for operations) and non-operating assets (assets that do not contribute to core operations) to focus purely on the capital used to generate NOPAT.²⁶, ²⁷

Interpreting the Adjusted Average ROIC

Interpreting Adjusted Average ROIC involves evaluating how effectively a company is converting the capital it employs into profits. A high Adjusted Average ROIC indicates that the company is efficient in its use of invested capital to generate Net Operating Profit After Tax (NOPAT). It suggests that management is adept at identifying and executing profitable projects and maintaining a competitive advantage.²⁵

Analysts often compare a company's Adjusted Average ROIC to its Weighted Average Cost of Capital (WACC). If the Adjusted Average ROIC is consistently greater than the WACC, it implies that the company is creating economic profit and increasing shareholder value.²⁴ Conversely, if ROIC is below WACC, the company may be destroying value, as the return generated from its investments does not cover the cost of financing those investments.²³ The magnitude of the spread between Adjusted Average ROIC and WACC is a key indicator of value creation. Furthermore, Adjusted Average ROIC is frequently used to compare a company's performance against its peers within the same industry, as it helps identify outperformers in terms of capital efficiency and profitability.²²

Hypothetical Example

Consider a hypothetical manufacturing company, "Widgets Inc.," which is being analyzed for its capital efficiency.

Year 1 Financials (Start of Period):

• Operating Income: $1,000,000
• Tax Rate: 25%
• Total Debt: $3,000,000
• Total Equity: $7,000,000
• Excess Cash: $500,000
• Non-operating Assets: $200,000
• R&D Expenses (expensed): $300,000 (assumed to be 70% capitalizable for adjusted ROIC, amortized over 3 years)

Year 1 Financials (End of Period):

• Operating Income: $1,200,000
• Tax Rate: 25%
• Total Debt: $3,200,000
• Total Equity: $7,500,000
• Excess Cash: $550,000
• Non-operating Assets: $210,000
• R&D Expenses (expensed): $350,000 (70% capitalizable, amortized over 3 years)

Calculations:

1. Calculate Adjusted NOPAT:

• Standard NOPAT (Start of Period): $1,000,000 * (1 - 0.25) = $750,000

• Standard NOPAT (End of Period): $1,200,000 * (1 - 0.25) = $900,000

• Capitalized R&D Adjustment: If 70% of R&D is capitalized and amortized over 3 years, then for Year 1, 70% of the $300,000 R&D is $210,000 added to invested capital. The amortization would be $210,000 / 3 = $70,000. This $70,000 would be added back to NOPAT (after tax). Similarly for the end of the period. This demonstrates the complexity, so for a simplified example, we'll illustrate the concept without full amortization schedules.

Let's assume for simplicity, the Adjusted NOPAT (after all relevant adjustments for the period) is calculated as:

• Adjusted NOPAT (Start) = $800,000
• Adjusted NOPAT (End) = $950,000

2. Calculate Adjusted Invested Capital:

• Invested Capital (Start of Period): ($3,000,000 + $7,000,000) - $500,000 - $200,000 = $9,300,000

• Add back capitalized R&D (start of year): Assuming $210,000 of R&D from prior periods is now capitalized on the balance sheet.

  • Adjusted Invested Capital (Start) = $9,300,000 + $210,000 = $9,510,000

• Invested Capital (End of Period): ($3,200,000 + $7,500,000) - $550,000 - $210,000 = $9,940,000

• Add back capitalized R&D (end of year): Assuming $245,000 (70% of $350,000) of new R&D is capitalized for the current year.

  • Adjusted Invested Capital (End) = $9,940,000 + $245,000 = $10,185,000

3. Calculate Average Adjusted Invested Capital:

• ($9,510,000 + $10,185,000) / 2 = $9,847,500

4. Calculate Adjusted Average ROIC:

• Adjusted Average ROIC = Adjusted NOPAT (for the year) / Average Adjusted Invested Capital
• If the Adjusted NOPAT for the full year was $950,000 (combining the effect of operating profit and tax-adjusted R&D add-backs):
• Adjusted Average ROIC = $950,000 / $9,847,500 (\approx) 9.65%

This adjusted figure provides a more comprehensive view of Widgets Inc.'s efficiency in generating returns from its total deployed capital, including the value-creating aspects of R&D.

Practical Applications

Adjusted Average ROIC is a critical metric used across various facets of finance and investing for its ability to provide a more accurate picture of a company's core profitability and efficiency.

• Investment Analysis: Investors utilize Adjusted Average ROIC to assess a company's ability to generate sustainable returns from its investments. Companies with consistently high Adjusted Average ROIC are often seen as having strong competitive advantages and effective capital allocation strategies. It helps in identifying quality businesses that can reinvest profits at attractive rates.²⁰, ²¹
• Valuation Models: Adjusted Average ROIC is a key input in sophisticated valuation models like Discounted Cash Flow (DCF) analysis.¹⁹ Higher ROIC can imply better future growth prospects and cash flow generation, leading to higher intrinsic valuations. Financial analysts use this metric to check their forecast assumptions, ensuring projected ROIC trends are consistent with the company's economic and competitive environment.¹⁸
• Corporate Strategy and Management Decisions: Corporate executives and management teams employ Adjusted Average ROIC to evaluate past investment decisions and guide future capital deployment. It helps them benchmark the profitability of different projects or divisions and allocate resources to initiatives that promise the highest returns.¹⁷ Understanding how various adjustments impact ROIC helps management refine their financial reporting and internal performance metrics.
• Competitive Benchmarking: By applying consistent adjustments across different companies, Adjusted Average ROIC allows for more meaningful comparisons between competitors, even if their accounting policies differ. This enables analysts to identify industry outperformers based on their true capital efficiency.¹⁶

Limitations and Criticisms

Despite its refinement, Adjusted Average ROIC is not without limitations and criticisms. One primary concern stems from the subjective nature of the adjustments themselves. Deciding which expenses to capitalize (e.g., R&D, advertising) and over what period to amortize them can introduce significant discretion, potentially leading to varied interpretations and impacting comparability across analyses.¹⁵ For example, a finance professor Aswath Damodaran has reportedly critiqued ROIC, stating that "I could write a paper on perverse ways you could destroy your company by raising your ROIC," highlighting how focus on a single metric, even adjusted, can lead to detrimental decisions if not viewed holistically.¹⁴

Another challenge lies in the data required for these adjustments, which may not always be readily available or transparent in public financial statements.¹³ Estimating non-operating assets or excess cash also requires judgment. Furthermore, like all historical financial ratios, Adjusted Average ROIC is backward-looking and does not guarantee future performance.¹¹, ¹² It can be less meaningful for early-stage or rapidly growing companies that are heavily investing in future growth without immediate corresponding profits, or for companies in sectors like financial institutions or real estate, where the concept of "invested capital" needs significant adaptation.¹⁰ While the aim is to provide a more robust measure, if the underlying accounting estimates for Operating Income or the calculation of Invested Capital are flawed, the Adjusted Average ROIC will inherit those inaccuracies.⁹

Adjusted Average ROIC vs. Return on Capital Employed (ROCE)

While both Adjusted Average ROIC and Return on Capital Employed (ROCE) are metrics used to assess how efficiently a company uses its capital to generate profits, they differ primarily in their specific definitions of "capital employed" and how profit is measured.

ROCE typically uses Earnings Before Interest and Taxes (EBIT) as its numerator, divided by Capital Employed (often defined as total assets minus current liabilities).⁸ This calculation does not usually make specific adjustments for items like capitalized R&D or excess cash, and it does not explicitly adjust for taxes in the profit figure, focusing purely on operating profit before tax.⁷

Adjusted Average ROIC, on the other hand, explicitly uses Net Operating Profit After Tax (NOPAT) in its numerator, which is EBIT adjusted for taxes, ensuring that the profit figure reflects earnings available after tax for capital providers.⁶ Crucially, it involves further specific adjustments to both NOPAT and invested capital to account for factors like capitalized intangible investments (e.g., R&D, brand building) and the removal of non-operating assets or excess cash from the capital base.⁵ The "average" component also implies using an average of invested capital over a period to better match the generated profit. The goal of Adjusted Average ROIC is to provide a more economically accurate and comparable measure of a company's true return on the capital directly deployed in its value-generating operations. This makes Adjusted Average ROIC often preferred by analysts seeking a deeper, more refined understanding of a company's underlying profitability and efficiency.⁴

FAQs

Why adjust ROIC?

Adjustments to ROIC are made to provide a more accurate and consistent view of a company's operational performance. Standard accounting rules can sometimes expense items (like R&D or advertising) that are, in essence, long-term investments. Adjusting for these, along with removing non-operating assets, helps analysts see the true return generated from the capital actively used to run the business. This leads to a better understanding of operational efficiency.

How does "average" factor into Adjusted Average ROIC?

The "average" in Adjusted Average ROIC typically refers to using the average of the beginning-of-period and end-of-period invested capital. This approach helps to align the capital base with the Net Operating Profit After Tax (NOPAT), which represents earnings generated over a period (e.g., a fiscal year), rather than a single point in time.

Is a high Adjusted Average ROIC always good?

Generally, a higher Adjusted Average ROIC is desirable as it indicates efficient use of capital to generate profits. However, it's crucial to compare it against the company's Weighted Average Cost of Capital (WACC) and industry peers.³ An Adjusted Average ROIC significantly above WACC suggests value creation, but an abnormally high figure might also warrant deeper investigation into the sustainability of such returns or the underlying assumptions in the adjustment process.

What are common adjustments made to ROIC?

Common adjustments include capitalizing expenditures that build future value, such as research and development (R&D) or significant advertising expenses, and then amortizing them over their useful life. Additionally, excess cash and non-operating assets are often removed from the invested capital base to focus solely on the capital used in core operations.²

Can Adjusted Average ROIC be used for all companies?

Adjusted Average ROIC is most effective for established, mature companies with stable operations. It can be less relevant for very early-stage companies, financial institutions, or real estate investment trusts (REITs) due to their unique capital structures and accounting practices. For these companies, other financial ratios or specific industry metrics may be more appropriate.¹