Reading Filings  ·  No. 4

When the denominator
changes.

Yesterday's reclassifications change one of the most-used ratios in equity research. Today, what they do to Microsoft's headline 49 percent.

Yesterday's piece was about three changes Mauboussin recommends to the cash flow statement. Today is about what one of those changes does to a number sitting in nearly every equity research report ever written: return on invested capital.

ROIC has a numerator (NOPAT, the operating profit available to every capital provider) and a denominator (invested capital, the assets the business needs to produce that NOPAT). The third reclassification from yesterday, capitalizing intangibles, changes both. The two changes don't cancel out the way intuition suggests they might.

The case study Mauboussin and Callahan walk through is Microsoft. For fiscal 2022, NOPAT of about $70 billion against average invested capital of $143 billion produced an ROIC of 49 percent. That is one of the highest ROICs in the Russell 3000 and it is the kind of figure that anchors valuation work for asset-light compounders. The figure isn't wrong; it is generated by an accounting framework that puts most of Microsoft's actual investment on the income statement instead of the balance sheet.

How the math works.

The intangible adjustment takes a portion of selling, general, and administrative expense and reclassifies it as an investment. Mauboussin and Callahan use 100 percent of R&D, 70 percent of sales and marketing, and 20 percent of general and administrative expense. Each capitalized investment is then amortized over a useful life that varies by category, with six years for R&D and two years for the others. Apply that to a software business and two things happen at once.

NOPAT goes up. The portion of SG&A that gets reclassified comes out of operating expense, which lifts operating income, which lifts NOPAT. The amortization of prior intangible investments offsets some of the gain, but for any company growing intangible investment, the operating-expense reduction is larger than the new amortization charge.

Invested capital goes up too. The capitalized intangibles get added to the balance sheet as an asset, and the asset accumulates over time as new investment exceeds amortization. Both numerator and denominator rise. For Microsoft, where intangible investment is large relative to NOPAT, the denominator effect is bigger than the numerator effect, and the headline ROIC falls.

Russell 3000 ex-financials  ·  1990–2021

11% → 8%

Share of companies in the highest-ROIC bin under traditional versus adjusted calculation. Outliers compress toward the middle.

What the result actually does.

The same adjustment runs the opposite way for low-ROIC firms. For a company whose accumulated intangible investment is large relative to a small or negative NOPAT, the numerator adjustment dominates. Snowflake is the example Mauboussin uses on the low end. Reported ROIC under traditional accounting was approximately negative 416 percent in fiscal 2022, dominated by GAAP losses against a small invested capital base. Apply the intangible adjustment, and ROIC moves to roughly positive 3 percent.

Across the Russell 3000 from 1990 through 2021, the aggregate average ROIC was 9.4 percent under the traditional calculation and 9.1 percent under the adjusted calculation. The average barely moved. What changed was the distribution. The traditional calculation puts 11 percent of companies in the highest-ROIC bin and 8 percent in the lowest. The adjusted calculation produces 8 percent and 4 percent. The outliers in both directions get pulled toward the middle.

The compression is the part most worth sitting with. The asset-light premium that traditional ROIC rewards is, to a meaningful extent, a measurement artifact. Once intangible investment is on the balance sheet where it economically belongs, the gap between the asset-light compounders and the asset-heavy industrials narrows. Some of the gap reflects real economic differences and some of it is just the accounting.

Why this matters for valuation work.

Most equity research uses ROIC two ways. The first is as a cross-sectional ranking signal, sorting which businesses earn above their cost of capital and which do not. The second is as an input to terminal-value assumptions in a DCF, where the long-run spread between ROIC and WACC drives the implied value beyond the explicit forecast period. Traditional ROIC distorts both uses in the same direction. Asset-light businesses look better than the underlying economics support, and the fade assumption in a DCF starts from an artificially elevated base.

Counterpoint Global itself uses adjusted ROIC for the valuation work that informs their fund. The standard exhibit they publish each year, plotting ROIC minus WACC against enterprise value to invested capital, uses the adjusted figure. The same exhibit produced from FactSet defaults will look different, point at the same companies and the same underlying economics, and produce different rankings.

The metric is not broken. The ratio is doing exactly what its inputs are telling it to do, and those inputs are a function of accounting standards from a different era of corporate investment. Whoever runs the screen has to decide whether the spreadsheet work to recategorize is worth a different ranking.

Have a good Tuesday.

— Marques

About the author

Marques Blank writes The Capital Memo. Northrop Grumman ($1.6B business unit), previously Citibank. CMA, MBA, Series 65.

Sources

Mauboussin, M. & Callahan, D. (2022). Return on Invested Capital: How to Calculate ROIC and Handle Common Issues. Consilient Observer, Counterpoint Global Insights, Morgan Stanley Investment Management, October 6.  ·  Mauboussin, M. & Callahan, D. (2022). ROIC and Intangible Assets. Consilient Observer, Counterpoint Global Insights, November 9.

For informational purposes only. Not investment advice. Specific securities mentioned are case studies, not recommendations. Past performance does not predict future results.