Return on Invested Capital

Return on Invested Capital (ROIC) evaluates companies by asking, How much net income has been generated per each dollar of invested capital? For instance, if a stakeholder gave one dollar to this company, how much money would the company earn by investing that one dollar? A ROIC of 5% means that a company earns 5 dollars per 100 dollars invested.

ROIC is often considered a more reasonable estimate of managerial performance than Return on Equity (ROE) because it takes into account investments by debt holders. Similarly, it is different from Return on Assets because it includes capital that shareholders have invested into the company.

Formula

ROIC = Net Income / Average Invested Capital

Cash Flow From Operating Activities

Cash flow from operating activities (CFO) is an accounting item that indicates the amount of money a company brings in from ongoing, regular business activities, such as manufacturing and selling goods or providing a service. Cash flow from operating activities does not include long-term capital or investment costs.

CFO can be calculated as follows:

Cash Flow From Operating Activities = EBIT – Taxes + Depreciation – Working Capital Investment

It is also known as operating cash flow (OCF) or net cash from operating activities.

Statement of Cash Flow

The statement of cash flows is one of the four basic financial statements required by GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards). It is concerned with the flow of cash into and cash out of the business, breaking the analysis down to operating, investing, and financing activities. The statement of cash flows helps investors evaluate the short-term viability of a company, particularly its ability to pay bills.

A substantial, positive cash flow is generally a sign of a healthy company. Investors also must remember that companies in growth mode often have a negative cash flow.

In a statement of cash flows, cash flows are separated into three components: cash flow from operating activities (or cash flow from operations), cash flow from investing activities, and cash flow from financing activities.

Cash flow from operations is the net amount of cash provided by the company’s operating activities. The operating section of the statement of cash flows shows such cash flows as cash received from customers and cash paid to suppliers.

Cash flow from investing activities includes the company’s investments in (or sales of) long-term assets—for example, PP&E and long-term investments in other companies.

Cash flow from financing activities relates to the company’s activities in raising or repaying capital. International Financial Reporting Standards (IFRS) allow the company to classify interest paid as either an operating or financing activity. Furthermore, IFRS allow dividends paid to be classified as either an operating or financing activity. Interestingly, under US generally accepted accounting principles (GAAP), interest expense paid to providers of debt capital must be classified as part of cash flow from operations (as is interest income) but payment of dividends to providers of equity capital is classified as a financing activity.

Computing FCFF from Net Income

FCFF is the cash flow available to the company’s suppliers of capital after all operating expenses (including taxes) have been paid and operating investments have been made. The company’s suppliers of capital include bondholders and common shareholders (plus, occasionally, holders of preferred stock, which we ignore until later). Keeping in mind that a noncash charge is a charge or expense that does not involve the outlay of cash, we can write the expression for FCFF as follows:

FCFF = Net income available to common shareholders (NI)
Plus: Net noncash charges (NCC)
Plus: Interest expense × (1 − Tax rate)
Less: Investment in fixed capital (FCInv)
Less: Investment in working capital (WCInv)

This equation can be written more compactly as: FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv
 
Consider each component of FCFF. The starting point in the equation above is net income available to common shareholders—the bottom line in an income statement. It represents income after depreciation, amortization, interest expense, income taxes, and the payment of dividends to preferred shareholders (but not payment of dividends to common shareholders).

Net noncash charges represent an adjustment for noncash decreases and increases in net income. This adjustment is the first of several that analysts generally perform on a net basis. If noncash decreases in net income exceed the increases, as is usually the case, the adjustment is positive. If noncash increases exceed noncash decreases, the adjustment is negative. The most common noncash charge is depreciation expense. When a company purchases fixed capital, such as equipment, the balance sheet reflects a cash outflow at the time of the purchase. In subsequent periods, the company records depreciation expense as the asset is used. The depreciation expense reduces net income but is not a cash outflow. Depreciation expense is thus one (the most common) noncash charge that must be added back in computing FCFF. In the case of intangible assets, there is a similar noncash charge, amortization expense, which must be added back. Other noncash charges vary from company to company.

After-tax interest expense must be added back to net income to arrive at FCFF. This step is required because interest expense net of the related tax savings was deducted in arriving at net income and because interest is a cash flow available to one of the company’s capital providers (i.e., the company’s creditors). In the United States and many other countries, interest is tax deductible (reduces taxes) for the company (borrower) and taxable for the recipient (lender). As we explain later, when we discount FCFF, we use an after-tax cost of capital. For consistency, we thus compute FCFF by using the after-tax interest paid.5

Similar to after-tax interest expense, if a company has preferred stock, dividends on that preferred stock are deducted in arriving at net income available to common shareholders. Because preferred stock dividends are also a cash flow available to one of the company’s capital providers, this item is added back to net income available to common shareholders in deriving FCFF.

Investments in fixed capital represent the outflows of cash to purchase fixed capital necessary to support the company’s current and future operations. These investments are capital expenditures for long-term assets, such as the property, plant, and equipment (PP&E) necessary to support the company’s operations. Necessary capital expenditures may also include intangible assets, such as trademarks. In the case of cash acquisition of another company instead of a direct acquisition of PP&E, the cash purchase amount can also be treated as a capital expenditure that reduces the company’s free cash flow (note that this treatment is conservative because it reduces FCFF). In the case of large acquisitions (and all noncash acquisitions), analysts must take care in evaluating the impact on future free cash flow. If a company receives cash in disposing of any of its fixed capital, the analyst must deduct this cash in calculating investment in fixed capital. For example, suppose we had a sale of equipment for $100,000. This cash inflow would reduce the company’s cash outflows for investments in fixed capital.

The company’s statement of cash flows is an excellent source of information on capital expenditures as well as on sales of fixed capital. Analysts should be aware that some companies acquire fixed capital without using cash—for example, through an exchange for stock or debt. Such acquisitions do not appear in a company’s statement of cash flows but, if material, must be disclosed in the footnotes. Although noncash exchanges do not affect historical FCFF, if the capital expenditures are necessary and may be made in cash in the future, the analyst should use this information in forecasting future FCFF.

The final point to cover is the important adjustment for net increases in working capital. This adjustment represents the net investment in current assets (such as accounts receivable) less current liabilities (such as accounts payable). Analysts can find this information by examining either the company’s balance sheet or its statement of cash flows.

Although working capital is often defined as current assets minus current liabilities, working capital for cash flow and valuation purposes is defined to exclude cash and short-term debt (which includes notes payable and the current portion of long-term debt). When finding the net increase in working capital for the purpose of calculating free cash flow, we define working capital to exclude cash and cash equivalents as well as notes payable and the current portion of long-term debt. Cash and cash equivalents are excluded because a change in cash is what we are trying to explain. Notes payable and the current portion of long-term debt are excluded because they are liabilities with explicit interest costs that make them financing items rather than operating items.

Estimating Free Cash Flow

Estimating FCFF or FCFE requires a complete understanding of the company and its financial statements. To provide a context for the estimation of FCFF and FCFE, we first use an extensive example to show the relationship between free cash flow and accounting measures of income.

For most of this section, we assume that the company has two sources of capital, debt and common stock. Once the concepts of FCFF and FCFE are understood for a company financed by using only debt and common stock, it is easy to incorporate preferred stock for the relatively small number of companies that actually use it.

FCFF Valuation Approach

The FCFF valuation approach estimates the value of the firm as the present value of future FCFF discounted at the weighted average cost of capital.

Because FCFF is the cash flow available to all suppliers of capital, using WACC to discount FCFF gives the total value of all of the firm’s capital.

The value of equity is the value of the firm minus the market value of its debt:

Equity value = Firm value – Market value of debt  

Dividing the total value of equity by the number of outstanding shares gives the value per share.

Free Cash Flow

Free cash flow is the amount of cash generated by a business that is available for distribution among its security holders. Security holders include debt holders, equity holders, preferred stock holders, and convertible security holders.

Specifically, free cash flow is used to pay dividends, make acquisitions, develop new products, invest in new property, plant and equipment, pay interest expenses, and reduce debt.

Types

There are two types of most commonly used free cash flow: free cash flow to the firm (FCFF) and free cash flow to equity (FCFE).

Free cash flow to the firm is the cash flow available to the company’s suppliers of capital after all operating expenses (including taxes) have been paid and necessary investments in working capital (e.g., inventory) and fixed capital (e.g., equipment) have been made. FCFF is the cash flow from operations minus capital expenditures. A company’s suppliers of capital include common stockholders, bondholders, and sometimes, preferred stockholders. The equations analysts use to calculate FCFF depend on the accounting information available.

Free cash flow to equity is the cash flow available to the company’s holders of common equity after all operating expenses, interest, and principal payments have been paid and necessary investments in working and fixed capital have been made. FCFE is the cash flow from operations minus capital expenditures minus payments to (and plus receipts from) debtholders.

When to Use

Free Cash Flow Analysis is one type of discounted cash flow analysis. Analysts like to use free cash flow as the return (either FCFF or FCFE) whenever one or more of the following conditions is present:

  • The company does not pay dividends.

  • The company pays dividends but the dividends paid differ significantly from the company’s capacity to pay dividends.

  • Free cash flows align with profitability within a reasonable forecast period with which the analyst is comfortable.

  • The investor takes a “control” perspective. With control comes discretion over the uses of free cash flow. If an investor can take control of the company (or expects another investor to do so), dividends may be changed substantially; for example, they may be set at a level approximating the company’s capacity to pay dividends. Such an investor can also apply free cash flows to uses such as servicing the debt incurred in an acquisition.

How to Use

The way in which free cash flow is related to a company’s net income, cash flow from operations, and measures such as EBITDA (earnings before interest, taxes, depreciation, and amortization) is important: The analyst must understand the relationship between a company’s reported accounting data and free cash flow in order to forecast free cash flow and its expected growth. Although a company reports cash flow from operations (CFO) on the statement of cash flows, CFO is not free cash flow. Net income and CFO data can be used, however, in determining a company’s free cash flow.

The advantage of FCFF and FCFE over other cash-flow concepts is that they can be used directly in a DCF framework to value the firm or to value equity. Other cash-flow- or earnings-related measures, such as CFO, net income, EBIT, and EBITDA, do not have this property because they either double-count or omit cash flows in some way. For example, EBIT and EBITDA are before-tax measures, and the cash flows available to investors (in the firm or in the equity of the firm) must be after tax. From the stockholders’ perspective, EBITDA and similar measures do not account for differing capital structures (the after-tax interest expenses or preferred dividends) or for the funds that bondholders supply to finance investments in operating assets. Moreover, these measures do not account for the reinvestment of cash flows that the company makes in capital assets and working capital to maintain or maximize the long-run value of the firm.

Using free cash flow in valuation is more challenging than using dividends because in forecasting free cash flow, the analyst must integrate the cash flows from the company’s operations with those from its investing and financing activities. Because FCFF is the after-tax cash flow going to all suppliers of capital to the firm, the value of the firm is estimated by discounting FCFF at the weighted average cost of capital (WACC). An estimate of the value of equity is then found by subtracting the value of debt from the estimated value of the firm. The value of equity can also be estimated directly by discounting FCFE at the required rate of return for equity (because FCFE is the cash flow going to common stockholders, the required rate of return on equity is the appropriate risk-adjusted rate for discounting FCFE).

The two free cash flow approaches, indirect and direct, for valuing equity should theoretically yield the same estimates if all inputs reflect identical assumptions. An analyst may prefer to use one approach rather than the other, however, because of the characteristics of the company being valued. For example, if the company’s capital structure is relatively stable, using FCFE to value equity is more direct and simpler than using FCFF. The FCFF model is often chosen, however, in two other cases:

  • A levered company with negative FCFE. In this case, working with FCFF to value the company’s equity might be easiest. The analyst would discount FCFF to find the present value of operating assets (adding the value of excess cash and marketable securities and of any other significant nonoperating assets1 to get total firm value) and then subtract the market value of debt to obtain an estimate of the intrinsic value of equity.

  • A levered company with a changing capital structure. First, if historical data are used to forecast free cash flow growth rates, FCFF growth might reflect fundamentals more clearly than does FCFE growth, which reflects fluctuating amounts of net borrowing. Second, in a forward-looking context, the required return on equity might be expected to be more sensitive to changes in financial leverage than changes in the WACC, making the use of a constant discount rate difficult to justify.

Macaulay Duration

The Macaulay duration is defined as the average time it takes to receive all the cash flows of a bond, weighted by the present value of each of the cash flows. It measures the number of years required to recover the true cost of a bond, considering the present value of all coupon and principal payments received in the future. Essentially, it is the payment-weighted point in time at which an investor can expect to recoup his or her original investment.

The Macaulay duration is quoted in “years” and it is the only type of duration with this unit. Interest rates are assumed to be continuously compounded.

Given its relative ability to predict price changes based on changes in interest rates, duration allows for the effective comparison of bonds with different maturities and coupon rates. For example, a 5-year zero coupon bond may be more sensitive to interest rate changes than a 7-year bond with a 6% coupon. By comparing the bonds’ durations, you may be able to anticipate the degree of price change in each bond assuming a given change in interest rates.

Utilizing Duration

Duration can help predict the likely change in the price of a bond given a change in interest rates. As a general rule, for every 1% increase or decrease in interest rates, a bond’s price will change approximately 1% in the opposite direction for every year of duration. For example, if a bond has a duration of 5 years, and interest rates increase by 1%, the bond’s price will decline by approximately 5%. Conversely, if a bond has a duration of 5 years and interest rates fall by 1%, the bond’s price will increase by approximately 5%.

Formula

Example

For example, for a two-year bond with a $1000 face value and one coupon payment every six months of $50, the duration (calculated in years) is:

Rules of Duration

When thinking about duration, a few general rules apply. With everything else being equal:

  • The duration of any bond that pays a coupon will be less than its maturity, because some amount of coupon payments will be received before the maturity date.

  • The lower a bond’s coupon, the longer its duration, because proportionately less payment is received before final maturity. The higher a bond’s coupon, the shorter its duration, because proportionately more payment is received before final maturity.

  • Because zero coupon bonds make no coupon payments, a zero coupon bond’s duration will be equal to its maturity.

  • The longer a bond’s maturity, the longer its duration, because it takes more time to receive full payment. The shorter a bond’s maturity, the shorter its duration, because it takes less time to receive full payment.