Let’s start by explaining a few concepts. Invested capital is the total cash investment that shareholders and debt-holders have made in a company. You can calculate it from the balance sheet by following a long but comprehensive explanation here. However, if you want a shortcut, just remember that
Invested Capital = Shareholder Equity + Total Liabilities – Current Liabilities
Return on Invested Capital quantifies how well a company generates cash flow relative to the capital it has invested in its business. Usually, it is calculated as follows:
ROIC = (Net Operating Profit – Adjusted Taxes)/Invested Capital
or
ROIC = NOPAT/Invested Capital
Some people like to use CROIC, or Cash Return on Invested Capital. In this case,
CROIC = Free Cash Flow/Invested Capital
One can also use
CROIC = Owner Earnings/Invested Capital
Since these are similar most of the time (not all the time).
I usually use CROIC. Free Cash Flow and Owner Earnings make more sense to me than NOPAT. Plus, we already learned how to calculate Owner Earnings.
So let’s crunch out CROIC for Microsoft (MSFT).
Here’s its balance sheet:
| In Millions of USD (except for per share items) | As of 2011-03-31 | As of 2010-12-31 | As of 2010-09-30 | As of 2010-06-30 | As of 2010-03-31 |
|---|---|---|---|---|---|
| Cash & Equivalents | 7,021.00 | 4,023.00 | 8,161.00 | 5,505.00 | 8,155.00 |
| Short Term Investments | 43,129.00 | 37,229.00 | 36,012.00 | 31,283.00 | 31,511.00 |
| Cash and Short Term Investments | 50,150.00 | 41,252.00 | 44,173.00 | 36,788.00 | 39,666.00 |
| Accounts Receivable – Trade, Net | 10,033.00 | 12,874.00 | 9,646.00 | 13,014.00 | 9,137.00 |
| Receivables – Other | - | - | - | - | - |
| Total Receivables, Net | 10,033.00 | 12,874.00 | 9,646.00 | 13,014.00 | 9,137.00 |
| Total Inventory | 1,056.00 | 861.00 | 1,242.00 | 740.00 | 501.00 |
| Prepaid Expenses | - | - | - | - | - |
| Other Current Assets, Total | 5,024.00 | 4,697.00 | 4,520.00 | 5,134.00 | 5,214.00 |
| Total Current Assets | 66,263.00 | 59,684.00 | 59,581.00 | 55,676.00 | 54,518.00 |
| Property/Plant/Equipment, Total – Gross | 17,533.00 | 17,078.00 | 16,713.00 | 16,259.00 | 15,765.00 |
| Accumulated Depreciation, Total | -9,564.00 | -9,279.00 | -8,942.00 | -8,629.00 | -8,393.00 |
| Goodwill, Net | 12,554.00 | 12,502.00 | 12,471.00 | 12,394.00 | 12,463.00 |
| Intangibles, Net | 840.00 | 992.00 | 1,077.00 | 1,158.00 | 1,282.00 |
| Long Term Investments | 10,748.00 | 10,022.00 | 9,211.00 | 7,754.00 | 7,797.00 |
| Other Long Term Assets, Total | 1,353.00 | 1,307.00 | 1,429.00 | 1,501.00 | 1,478.00 |
| Total Assets | 99,727.00 | 92,306.00 | 91,540.00 | 86,113.00 | 84,910.00 |
| Accounts Payable | 3,829.00 | 3,863.00 | 3,654.00 | 4,025.00 | 3,279.00 |
| Accrued Expenses | 2,917.00 | 2,402.00 | 2,252.00 | 3,283.00 | 2,885.00 |
| Notes Payable/Short Term Debt | 0.00 | 0.00 | 1,000.00 | 1,000.00 | 2,249.00 |
| Current Port. of LT Debt/Capital Leases | - | - | - | - | - |
| Other Current liabilities, Total | 17,296.00 | 18,047.00 | 18,951.00 | 17,839.00 | 18,011.00 |
| Total Current Liabilities | 24,042.00 | 24,312.00 | 25,857.00 | 26,147.00 | 26,424.00 |
| Long Term Debt | 11,915.00 | 9,671.00 | 9,665.00 | 4,939.00 | 3,746.00 |
| Capital Lease Obligations | - | - | - | - | - |
| Total Long Term Debt | 11,915.00 | 9,671.00 | 9,665.00 | 4,939.00 | 3,746.00 |
| Total Debt | 11,915.00 | 9,671.00 | 10,665.00 | 5,939.00 | 5,995.00 |
| Deferred Income Tax | 1,185.00 | 826.00 | 540.00 | 229.00 | 828.00 |
| Minority Interest | - | - | - | - | - |
| Other Liabilities, Total | 9,133.00 | 9,016.00 | 8,536.00 | 8,623.00 | 8,202.00 |
| Total Liabilities | 46,275.00 | 43,825.00 | 44,598.00 | 39,938.00 | 39,200.00 |
| Redeemable Preferred Stock, Total | - | - | - | - | - |
| Preferred Stock – Non Redeemable, Net | - | - | - | - | - |
| Common Stock, Total | 63,234.00 | 61,646.00 | 61,935.00 | 62,856.00 | 62,517.00 |
| Additional Paid-In Capital | - | - | - | - | - |
| Retained Earnings (Accumulated Deficit) | -11,592.00 | -14,862.00 | -16,512.00 | -17,736.00 | -18,260.00 |
| Treasury Stock – Common | - | - | - | - | - |
| Other Equity, Total | 1,810.00 | 1,697.00 | 1,519.00 | 1,055.00 | 1,453.00 |
| Total Equity | 53,452.00 | 48,481.00 | 46,942.00 | 46,175.00 | 45,710.00 |
| Total Liabilities & Shareholders’ Equity | 99,727.00 | 92,306.00 | 91,540.00 | 86,113.00 | 84,910.00 |
| Shares Outs – Common Stock Primary Issue | - | - | - | - | - |
| Total Common Shares Outstanding | 8,431.00 | 8,403.00 | 8,562.00 | 8,668.00 | 8,762.00 |
Look in the latest column,second from the left, the heading of which is highlighted in glorious green.
Invested Capital = $99,727 – $24,042 = $75,685 million bucks, or $75.69 billion bucks.
We are going to use Owner Earnings (OE) from the fiscal 2010, and, since you already know how to calculate it, I’ll just give it to you. It is $20,996.50 million bucks. Of note, MSFT’s Owner Earnings for the first 9 months of 2011 are almost the same as Owner Earnings for the entire 2010… So much for the so called stodgy company!
Given that OE for 2011 will almost certainly exceed that of 2010, we will therefore significantly underestimate the CROIC. Another way of doing this would be to use OE from the Trailing 12 Months (TTM), but I feel lazy right now and since we are doing this just to illustrate the principle, we’ll be fine.
OK. What’s the CROIC?
CROIC = $20,996.50/$75,685 = 28%. So, for every dollar invested in the company for 1 year, we get back $1.28. For comparison, for every $1 invested in a government bond right now, you’ll be lucky to get $1.04 per year. This sounds amazing, and it is. CROIC is a very effective way to identify profitable companies.
Of course, it’s not all gravy. Later, we will explore the concept of WACC, or Weighted Average Cost of Capital. You see, $1 invested into a company was not free to the company – shareholders clamor for share repurchases and dividends, and bondholders clamor for interest payments… So, is the true return on invested capital, or TRIC, equal CROIC – WACC? Stay tuned:)
Disclosure: Long MSFT. A mention of specific securities does not constitute a recommendation to buy or sell. Securities investing involves risk and is not suitable for everyone.