What Is Adjusted Economic ROIC?
Adjusted Economic ROIC, or Adjusted Economic Return on Invested Capital, is a financial metric used within the broader field of Financial Analysis and Valuation to assess a company's efficiency in allocating the capital at its disposal to profitable investments. Unlike traditional Return on Invested Capital (ROIC), Adjusted Economic ROIC incorporates various adjustments to accounting figures to provide a more accurate depiction of the economic reality of a business's performance. These adjustments typically aim to normalize distortions that can arise from Generally Accepted Accounting Principles (GAAP) or other accounting conventions, offering a clearer view of the true cash-generating ability from invested capital. The goal of using Adjusted Economic ROIC is to better understand how effectively a company is creating wealth above its cost of capital.
History and Origin
The concept of adjusting accounting figures to derive a more "economic" view of performance has roots in the broader theory of economic profit, which dates back to Alfred Marshall's work on economic rent in the late 19th and early 20th centuries. The modern application of these ideas in corporate finance gained significant traction in the 1980s and 1990s with the popularization of metrics like Economic Value Added (EVA). These concepts emphasized that a company truly creates value only when its returns exceed its Weighted Average Cost of Capital (WACC). As financial analysis evolved, practitioners and academics began to refine traditional accounting ratios, including Return on Invested Capital, by making specific adjustments to better reflect cash flows and underlying economic assets rather than just book values. For instance, the re-emphasis on economic profit concepts, which underpins the philosophy behind Adjusted Economic ROIC, saw a resurgence in business discussions as highlighted by financial commentary on its continued relevance.5
Key Takeaways
- Adjusted Economic ROIC refines traditional ROIC by making non-GAAP adjustments to financial statements, aiming for a truer economic picture.
- It provides insight into how efficiently a company generates profits from its invested capital after accounting for its cost.
- The adjustments often involve reclassifying certain expenses as investments or removing non-operating items from the capital base and earnings.
- This metric is particularly valuable in valuation and assessing a company's long-term competitive advantages.
- A higher Adjusted Economic ROIC typically indicates superior capital allocation and strong performance.
Formula and Calculation
The calculation of Adjusted Economic ROIC begins with a traditional ROIC framework, which measures how much profit a company generates for each dollar of capital invested. However, it incorporates specific "economic" adjustments. While there is no single standardized formula for Adjusted Economic ROIC, the general approach involves adjusting Net Operating Profit After Tax (NOPAT) and the invested capital base.
A simplified conceptual formula can be expressed as:
Where:
- Adjusted NOPAT = Operating Income (before interest and taxes) (\times) (1 – Tax Rate) (\pm) Adjustments (e.g., adding back research & development expenses if treated as investments, adjusting for non-recurring items).
- Adjusted Invested Capital = Total Assets - Non-interest Bearing Current Liabilities (\pm) Adjustments (e.g., capitalizing operating leases, removing excess cash, adjusting for goodwill and intangible assets to reflect true operational investments, reclassifying certain capital expenditures and working capital components).
These adjustments aim to convert accounting figures from the balance sheet and income statement into figures that reflect the true economic capital employed and the returns generated.
Interpreting the Adjusted Economic ROIC
Interpreting Adjusted Economic ROIC involves comparing it to a company's Weighted Average Cost of Capital (WACC) and to the Adjusted Economic ROIC of peers or industry averages. A company that consistently generates an Adjusted Economic ROIC higher than its WACC is creating shareholder value, as it is earning a return above the minimum required by its investors. Conversely, if Adjusted Economic ROIC is consistently below WACC, the company is destroying value.
The magnitude of the difference between Adjusted Economic ROIC and WACC, often referred to as the "economic spread," indicates the strength of a company's competitive advantage or economic moat. Companies with durable competitive advantages often exhibit persistently high Adjusted Economic ROIC figures. This metric is considered a more robust indicator than traditional accounting ratios because it attempts to remove accounting distortions like varying depreciation schedules or the expensing of certain investments that have long-term benefits, such as research and development.
Hypothetical Example
Consider "InnovateCo," a hypothetical technology firm. In its reported financial statements, InnovateCo expensed $50 million in research and development (R&D) this year, even though this R&D is expected to generate benefits for the next five years. InnovateCo also has $100 million in operating lease obligations that are treated as off-balance sheet items.
To calculate InnovateCo's Adjusted Economic ROIC:
- Adjust NOPAT: If InnovateCo's reported NOPAT was $150 million, and a decision is made to capitalize 80% of the $50 million R&D expense (i.e., $40 million) and amortize it over 5 years. This would mean adding back the $40 million initially expensed, then subtracting the current year's amortization of $8 million ($40 million / 5 years). So, Adjusted NOPAT becomes $150M + $40M - $8M = $182 million.
- Adjust Invested Capital: If InnovateCo's reported Invested Capital was $800 million. The capitalized R&D adds $40 million to assets. Additionally, the operating leases, if capitalized, might add $70 million to the invested capital base. So, Adjusted Invested Capital becomes $800M + $40M + $70M = $910 million.
- Calculate Adjusted Economic ROIC:
Adjusted Economic ROIC = $\frac{$182 \text{ million}}{$910 \text{ million}} = 0.20 \text{ or } 20%$.
If InnovateCo's WACC is 10%, an Adjusted Economic ROIC of 20% indicates that the company is generating significant economic profit and creating substantial shareholder value.
Practical Applications
Adjusted Economic ROIC is a powerful tool in several areas of finance and investing. Fund managers and equity analysts often use it to identify high-quality companies with sustainable competitive advantages, as companies with higher and more stable Adjusted Economic ROIC often demonstrate superior long-term performance. Investors focused on long-term value creation, like those seeking companies with strong economic moats, frequently employ this metric. For instance, reputable investment research firms utilize Return on Invested Capital (ROIC) as a core metric for identifying companies with durable competitive advantages.
4It is also vital in corporate strategic planning. Management teams can use Adjusted Economic ROIC to evaluate the true profitability of business segments or specific projects, guiding capital allocation decisions and ensuring that investments genuinely contribute to value creation. Furthermore, in mergers and acquisitions, Adjusted Economic ROIC can provide a more realistic assessment of a target company's operational efficiency and its potential contribution to the combined entity's enterprise value. Understanding a company's true economic returns, as opposed to purely accounting returns, can also help in forecasting future free cash flow generation.
Limitations and Criticisms
While Adjusted Economic ROIC offers a more nuanced view of corporate performance, it is not without limitations. The primary criticism stems from its "adjusted" nature, meaning it deviates from standard GAAP accounting. The specific adjustments made can vary significantly between analysts, leading to a lack of comparability across different analyses or companies. Unlike standardized GAAP metrics, there is no universal framework for calculating Adjusted Economic ROIC, making it a "non-GAAP financial measure." The U.S. Securities and Exchange Commission (SEC) provides extensive guidance on the use of non-GAAP financial measures, emphasizing the need for clear reconciliation to GAAP measures and avoiding misleading presentations. A3cademic research also highlights challenges with non-GAAP measures like EBITDA, which, like Adjusted Economic ROIC, rely on discretionary adjustments, potentially leading to inconsistencies and affecting their decision-usefulness.
2Furthermore, the quality and relevance of Adjusted Economic ROIC heavily depend on the judgment exercised in making these adjustments. Incorrect or overly aggressive adjustments can misrepresent a company's true economic performance. It also requires access to detailed financial information, which may not always be publicly available, especially for private companies. Critics also point out that while useful for analyzing capital efficiency, it doesn't tell the whole story about a company's financial health, such as its liquidity or leverage.
Adjusted Economic ROIC vs. Return on Invested Capital (ROIC)
The fundamental difference between Adjusted Economic ROIC and Return on Invested Capital (ROIC) lies in their underlying inputs. Traditional ROIC uses figures directly from a company's financial statements, which are prepared according to accounting standards like GAAP or IFRS. While standard ROIC provides a useful benchmark, it can be influenced by accounting policies related to depreciation, amortization, or the capitalization of certain expenditures.
Adjusted Economic ROIC, on the other hand, seeks to transcend these accounting conventions by making discretionary adjustments to both the numerator (NOPAT) and the denominator (invested capital). These adjustments aim to reflect the true economic reality of a company's operations and investments. For example, Adjusted Economic ROIC might capitalize research and development expenses that GAAP requires to be expensed, or it might reclassify operating leases as debt, thereby adjusting the capital base to include more economically relevant assets. The confusion often arises because both metrics measure capital efficiency, but Adjusted Economic ROIC endeavors to strip away accounting noise to reveal a purer economic return.
FAQs
What types of adjustments are typically made in Adjusted Economic ROIC?
Common adjustments include capitalizing operating leases, treating research and development or advertising expenses as investments rather than immediate expenses, normalizing non-recurring items, and adjusting for certain goodwill or excess cash to get a clearer picture of operational capital.
Why is Adjusted Economic ROIC considered more "economic" than traditional ROIC?
It's considered more "economic" because it attempts to reflect the true economic capital employed and the actual cash-generating capabilities of a business, rather than relying solely on accounting book values and accruals. This often involves reclassifying items to better align with their long-term investment nature versus short-term expenses.
Can Adjusted Economic ROIC be negative?
Yes, Adjusted Economic ROIC can be negative. A negative figure indicates that the company is not even generating enough profit to cover its operating costs, let alone a return on its invested capital, or that its adjustments reveal a significant destruction of economic value.
Is Adjusted Economic ROIC regulated?
No, Adjusted Economic ROIC itself is not directly regulated, as it is a non-GAAP financial measure. However, public companies presenting any non-GAAP financial measures, including those that might underpin an Adjusted Economic ROIC calculation, must comply with SEC regulations regarding their presentation and reconciliation to GAAP figures to ensure they are not misleading.
1### How does Adjusted Economic ROIC relate to Value Creation?
Adjusted Economic ROIC is directly linked to value creation. When a company's Adjusted Economic ROIC consistently exceeds its Weighted Average Cost of Capital (WACC), it indicates that the company is generating returns above what investors require, thereby creating economic value and increasing shareholder wealth.