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Invested Capital

The sum of all cash that has been invested in a company over its life without regard to financing form or accounting name. It is the total of investments in the business from which revenue is derived. It can be calculated two mathematically equivalent ways as shown in Figure 1.

Figure 1
Formula for Invested Capital

formula for invested capital

* NIBCLs - stands for Non-Interest-Bearing Current Liabilities
* * Includes leased assets
Source: New Constructs, LLC

Below are the primary accounting distortions in reported financial statements that require economic translation and adjustment for the Invested Capital calculation.
  1. Capitalized Expense
  2. Excess Cash
  3. LIFO Reserve
  4. Other Non-cash Reserve
  5. Deferred Revenue
  6. Operating Lease
  7. Accumulated Goodwill Amortization
  8. Unrecorded Goodwill derived from acquisitions recorded under the Pooling Method of Accounting
  9. After-tax Portion of Asset Write-downs
  10. Investments in Unconsolidated Subs/Minority Interests
  11. Unrealized (Gains)/Losses on Investments
  12. Over/Under-funded Pensions
Average Invested Capital is the average of beginning and ending invested capital. If the company discloses the purchase price and closing date of an acquisition, we weight the acquired invested capital by the percent of the fiscal year the acquisition was held.
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The after-tax operating cash generated by the business, excluding non-recurring losses and gains, financing costs, and goodwill amortization and including the compensation cost of employee stock options (ESOs). It can be calculated two mathematically equivalent ways:

Figure 2
Formula for NOPAT

formula for NOPAT

Source: New Constructs, LLC

Below are the primary accounting distortions in reported financial statements that require economic translation and adjustment for the NOPAT calculation.
  1. Capitalized Expenses
  2. Income from Unconsolidatebcinstuwd Subsidiaries
  3. Restructuring/Non-recurring Charges
  4. All Non-operating Items below EBI
  5. All After-tax Items
  6. Value of Employee Stock Options (ESOs) issued in a given year
  7. Operating Leases
  8. Over/Under-funded Pension

Unlevered NOPAT Per Share

EqualsNOPAT/Basic Shares Outstanding. Note that we use Basic Shares Outstanding because we account for Employee Stock Option expenses in our calculation of NOPAT

NOPAT Margin is equal to NOPAT/Total Operating Revenues.

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Weighted-Average Cost of Capital (WACC) is the average of debt and equity capital costs that all publicly traded companies with debt and equity stakeholders incur as a cost of operating. Below we provide the details behind our WACC calculations.

Cost of Equity
  • Our cost of equity calculation is based on the Capital Asset Pricing Model methodology.
  • We use the market value of equity when calculating all Total Adjusted Market Capital ratios.
  • The Equity Risk Premium is calculated as the average of the current implied Equity Risk Premium and the historical implied Equity Risk Premium.
  • Though there are many other more complicated approaches for arriving at a firm's cost of equity, we do not feel their additional complexity offers commensurate accuracy. CAPM is simple, gets us close enough and it is easy to implement consistently across all companies we analyze.
  • For Beta, we use consistent values to avoid this variable having an inappropriately large impact on the WACC calculation. We apply industry and sector averages for beta to individual companies. Industry and sector averages are based on the actual individual company betas, which we calculate based on daily prices over the past 5 years. We assign the industry or sector averages where we see individual beta values clustered most uniformly within industries or sectors, respectively.
Cost of Debt
  • The cost of debt capital should represent the business' long-term marginal borrowing rate.
  • The Risk-Free Rate (RFR) is approximated by the 30-year Treasury Bond. If the 30-year rate is not available, the 20-year rate is used.
  • To the RFR, we add the debt spread associated with the debt rating on the company's long-term debt.
  • The resulting pre-tax cost of debt is then multiplied by (1 - marginal tax rate).
  • We use debt ratings from Moody's or S&P.
WACC Formula
WACC = ( Ke ) * (E/TC) + (Kd * (1-T)) * (D/TC)+Kp * (P/TC)
Where Ke = Cost of Equity
E = Total Equity
Kd = Cost of Debt
D = Total Debt
Kp = Cost of Preferred
P = Preferred Capital
E/TC = Equity Total Adjusted Market Capital Ratio
D/TC = Debt to Total Adjusted Market Capital Ratio
P/TC = Preferred Stock to Total Adjusted Market Capital Ratio
T = Tax Rate
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Details of the Economic Value Drivers

Revenue CAGR

The Revenue Compounded Annual Growth Rate (CAGR) is a pure measure of the growth of a business. Revenue CAGR has no bearing on ROIC or Economic Earnings Margin and does not affect the level of a company's profitability.

Return on Invested Capital

Return on Invested Capital (ROIC) is the true measure of a business' operating profitability. It represents the cash flow derived from all capital invested in the business. It is equal to NOPAT divided by Average Invested Capital. It can also be calculated by multiplying the NOPAT Margin by Average Invested Capital Turns.

Economic Earnings Margin

ROIC minus WACC equals the truest measure of a business' profitability. This metric measures for the net cash flow returns to shareholders adjusted for the risk associated with the business model employed to achieve those returns. In essence, Economic Earnings Margin directly measure a firm's ability to create or destroy value for its shareholders.

Free Cash Flow

Reflects the amount of cash free for distribution to both debt and equity shareholders. It is calculated by subtracting the change in Invested Capital from NOPAT.

Economic Earnings

Quantifies the amount of shareholder value a company creates or destroys. It can be calculated two mathematically equivalent ways:

Residual income approach:
Economic Earnings = (ROIC - WACC) * Average Invested Capital
Refined earnings approach:
Economic Earnings = NOPAT - (Average Invested Capital * WACC)

Economic Earnings Per Share

Equals Economic Earnings/Basic Shares Outstanding. Note that we use Basic Shares Outstanding because we account for Employee Stock Option expenses in our calculation of NOPAT.

GAP (Growth Appreciation Period)

The Growth Appreciation Period is the amount of time (usually expressed in years) that a business can be expected to earn positive Economic Earnings Margin (ROIC greater than WACC) on new investments. Put simply, GAP is the amount of time a business can grow its economic cash flow. After the GAP, it is assumed that incremental investments by the business earn ROIC equal to WACC or the Net Present Value of all investments equal zero. Warren Buffett refers to GAP as the moat around a business' castle. It is also known as the CAP (Competitive Advantage Period) and the forecast growth horizon.

Our dynamic DCF model calculates share prices for attributable to multiple GAP scenarios. For example, the value of the company with a twenty-year forecast growth horizon assumes the company will enjoy a twenty-year GAP. Without a model that encompasses this long-term approach, investors are unable to assess the complete expectations embedded in any asset price.

Growth Depreciation Period (GDP)

GDP is the amount of time a business destroys value by allocating capital to projects that earn negative Economic Earnings Margin (ROIC below WACC).

Market-Implied GAP

MIGAP is the number of years that a company's stock market price implies it will earn ROIC greater than WACC on incremental investments. Provided that the estimates entered on the forecast page are based on market consensus projections, the MIGAP represents the forecast horizon needed in a DCF model to arrive at a value equal to the current market price.

Consistency and Integrity for All Key Calculations

It is important to note that our model ensures consistent treatment of all adjustments, especially the calculations of NOPAT, Invested Capital and WACC. In other words, the model guarantees that any adjustment made to NOPAT is properly reflected in the calculation of Invested Capital. For example, when Goodwill expense is removed from NOPAT, the related Accumulated Goodwill Amortization is added to Invested Capital. This methodology ensures that no adjustment to the financial statements is double-counted and that the ROIC calculation has maximum integrity.

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