After enduring the political grandstanding last week at least Jonathon Shapiro penned a decent article on the different return on capital measures - can skip the first quarter of the article if you want.
A curious quirk of Australia’s version of capitalism is that our business leaders must assure their shareholders they’re making good money while at the same time convincing politicians they’re doing it tough.
And so, naturally, it leads to some confusion about what facts and figures should be used to determine the greater truth, as it did as last week’s Senate inquiry into supermarkets.
In the aftermath of those fiery exchanges, we’ve found this debate around profit measures runs deeper than we appreciated. In fact, this is a complicated and subjective task that divides even the most learned scholars of corporate balance sheets.
Greens senator Nick McKim and outgoing Woolworths chief executive Brad Banducci at the Senate hearing last week. Dion Georgopoulos
To recap, last week Greens senator Nick McKim skewered outgoing Woolworths chief executive Brad Banducci claiming the retailer had a return on equity of 26 per cent – more than double that of the big banks, which he claimed are the world’s most profitable.
McKim pointed to this ROE as evidence that Woolworths was “making off like bandits”, which the Greens’ social media team packaged into a punchy TikTok clip.
The theatrics aside, Banducci and Coles chief executive Leah Weckert’s response was that return on invested capital (ROIC) and return on capital employed (ROCE) were far more appropriate benchmarks than ROE.
This is because ROE only measured the returns that accrue to shareholders, while the other measures capture the returns generated to all financiers, including debt providers.
This matters because a company can easily increase ROE by using more debt and less equity to finance its operations, but that higher number won’t tell us much about how well the business is tracking.
Then there are the historic accounting issues alluded to by Weckert. In fact, by looking at other sectors it’s clear ROE tells us little about monopolistic powers.
Qantas, the subject of a great deal of customer and political ire, has an ROE in the thousands because write-downs during the COVID-19 pandemic wiped out its accounting equity to zero. Toll road operator Transurban, by contrast, barely has a positive ROE, despite clipping its inflation-adjusted tickets on motorists with relative ease.
And so, there is good reason to defer to other measures, such as ROIC, which are agnostic on the financing choices and less distorted by accounting policies.
But they are not without their flaws. To understand why, a good place to start is to define these measures of returns.
ROIC is the ratio of profits or earnings generated relative to the capital invested into the business to generate those profits.
Michael Mauboussin – one of the world’s most respected valuations experts – has written extensively on ROIC. He says that in order for companies to make money, they must spend it. So, ROIC reflects the extent to which they’re able to do this. The profit is the “making money” part, and the invested capital is the “spending money” part.
“A high ROIC indicates that a company is generating a healthy level of profits on its investment,” he says.
That sounds simple enough. But like all accounting ratios, ROIC can go a little rogue. Executives can massage this figure by adjusting the profit numerator upwards; for instance, by moving expenses below the line.
They can also deflate the denominator, or the invested capital component. For instance, a company might exclude any item that they don’t agree is a debt, or engage in factoring to mask a debt. Write-downs and impairments also reduce the equity capital that forms part of the invested capital number, to lifting the overall return on invested capital.
There are some examples of this. Some in the market with long memories cite Newcrest Mining’s write-down of the Lihir gold mine in Papua New Guinea, which helped management hit its return on capital target by reducing the denominator.
Aswath Damodaran, another heralded valuations expert, isn’t all that enamoured with the concept of ROIC, even though he says he calculates this figure every year for 47,000 companies around the world.
“I can make a really bad company have a high return on capital if you give me enough accounting discretion to play that game,” he explained on a podcast in 2022.
For instance, he says accounting debris created by highly acquisitive companies complicates the ROIC calculations, as does a preference for leasing assets, which reduces the debt contribution to invested capital.
As an example, Damodaran pointed to Apple, which has a negative ROIC. This is because its cash exceeds the value of its debt and equity, resulting in a negative invested capital figure. But it’s misleading to conclude Apple is a poorly run company or a bad investment.
Overall, he says ROIC has its place. But investors that rely on it should recognise it’s backward looking and more appropriate for older, more mature companies. For younger, faster-growing companies, ROIC is a meaningless number.
Traders concede that equity sales desks will seldom, if at all, refer to a company’s ROIC. But investors say there should be a greater focus on these ratios, relative to simpler measures such as price-to-earnings ratios.
They’re really trying to work out how good a company is at investing capital to generate a return that exceeds the cost of capital, and that helps them identify which companies are better or worse than their multiples suggest.
“What we really want to know is how much money have you invested in the business over time and what return are you getting on that capital,” says one investor.
And so it appears that ROIC – and even return on incremental invested capital – could be a north star to determine management excellence.
But even in this highly detailed pursuit of capital allocation prowess, there are some cautionary tales. Damodaran reminds us of Stern Stewart, a management consulting firm that was all the rage in the 1990s.
Stern Stewart championed EVA, or economic value added, which was built into the remuneration structures of half of the Fortune 500 companies and several ASX firms.
EVA was similar to return on invested capital, and factored in the cost of capital to come up with a score of economic value add. These scores helped to reveal Australia’s top “wealth creators”. But EVA is now somewhat of a relic and barely warrants a mention.
That’s because any number that is tied to an incentive is subject to gaming. Management and staff worked out the inputs and focused their businesses to lift the EVA that determined their bonus at the expense of shareholder returns.
A classic example is National Australia Bank which had trumpeted the EVA as a way to align the interests of shareholders and management.
But in 2004, the bank’s chief financial officer Michael Ullmer revealed “the dysfunctional outcomes” that resulted from the obsession in this EVA number in its institutional bank.
Executives were paid bonuses based on their ability to lift the lender’s so-called economic value. But in the institutional unit, it led bankers to expand risk weighted assets, even though these new loans added little or no profit and weakened margins.
The EVA measure had worked at some companies, but Ullmer pledged to rely on measures that led to a “better alignment of the interests of shareholders”.
This, he said, was “good old-fashioned growth in cash [earnings per share]”.
And so, we must conclude that the power of incentives can overwhelm any greater truths that can be derived by accounting ratios.
Executives will focus on whatever number they’re paid to – then work out what to tell us that means. And investors will have to work through those numbers to sort the money printers from the money burners.