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Author: TMFValuemoosie Big gold star, 5000 posts Old School Fool Coverage Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 23720  
Subject: Calculating ROIC part 1: NOPLAT Date: 9/16/2009 11:05 AM
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Hi folks,

This is part 2 of my little ROIC cross-post.

A quick recap:
In Part 1 of this little series we calculated the IC portion of ROIC. Today we're walking through the other half: NOPLAT, which is the after-tax income generated by that Invested Capital. Like we did for IC, we'll show two ways to do the calculation, and we'll use that to check our work.

By the end of this post, we'll have calculated ROIC, which is NOPLAT / Invested Capital.

Remember, this is whole-firm analysis. The idea is to isolate and measure operational capability and efficiency regardless of the debt vs. equity balance the company has chosen. A company with poor ROIC doesn't need more capital - it would just be wasted.

Separate from, and not addressed by this analysis is the "correct" balance of debt vs. equity. Debt is generally cheaper than equity, but too much of it and there's not much room for error before the income won't cover the interest payments, or a debt covenant is tripped. That said, within reason, a company can often be more efficient financially by taking on a little debt, as long as it has more opportunities to deploy capital at high ROIC.

We're using Starbucks as the example. Here's their latest 10-K, which is where I'm getting all the numbers. Mostly from the primary statements, plus a bit of rummaging around in the footnotes:

What is NOPLAT?
NOPLAT means Net Operating Profit Less Adjusted Taxes. The calculation of NOP excludes any non-operating income and expense. What are these? A common non-operating expense is interest payments on debt. Interest earned on an excess cash hoard is non-operating income. Gains or losses on long-term investments and non-consolidated cross-holdings, and on sales of property from discontinued operations are also non-operating items.

To get from NOP to NOPLAT, we have to deduct taxes. Reported taxes are a good place to start, but have to be adjusted to undo the effects of taxation on non-operating income and expenses.

Operating Income consists of Revenue less Cost of Goods Sold, less Operating Expenses. NOP is similar, but a bit more selective. Amortization of intangibles and goodwill impairments are included in operating expenses. In part 1 of this series we reclassified these as equity equivalents. To remain consistent with this, we don't want to treat them as expenses, and must leave them in NOP. This will usually require a little digging in the "Goodwill" footnote to the financial statements.

There's one other thing that should be added to NOP. Remember in Part 1 we glossed over Operating Lease capitalization as a useful reclassification, but outside our scope. The effect on the income statement is that rent expense is broken into interest and depreciation. Rent is already included in expenses deducted from operating income. But interest is a financing, not operational, expense, so must be added back.

- Cost of Goods Sold
- Operating Expenses (including amortization and impairments,
and lease rent)
Operating income
+ Intangibles amortization (add back)
+ Goodwill impairments (add back)
+ Implied operating lease interest (add back interest portion of rent)
Net Operating Profit

Depending on the layout of the income statement, it might be just as easy to start with reported Operating Income, instead of calculating it yourself. Just be sure you understand what it does and does not contain.

We need to decide on a tax rate for making the adjustments from reported tax to tax on NOP. I prefer to use the marginal rate, which is simply federal plus state, and excludes any other adjustments. This is most likely what the company would pay on the next dollar of income. You can almost always find this information in an "Income Taxes" footnote in the 10-K. For Starbucks it's 37.8% and 38.4% for 2008 and 2007 respectively.

Remaining consistent with Part 1, where we treated Deferred Tax Liability as an equity equivalent, we make a final tax adjustment to get from accounting to cash taxes. Remember, a growing company will often report higher tax than it actually pays, and will record the difference as a deferred tax liability, overstating the actual tax burden. To calculate actual cash taxes, we subtract the increase in deferred tax liability from reported taxes.

Putting it all together:
Time to put it all together with some numbers. Note that some companies don't break out non-operating income vs. expense, just netting them in a single entry. While perhaps not as clearly showing the process, that works just fine. First we calculate intangibles amortization by comparing current and prior year's cumulative amortization.

2008 2007 2006
Accumulated amortization 5.9 4.3 3.4
Amortization of intangibles 1.6 0.9 (a)

Net deferred tax liability -234.2 -129.5 -88.8
Increase in deferred tax liab -104.7 -40.7 (e)

Revenue 10383.0 9411.5
- Cost of sales 4645.3 3999.1
- Store operating expenses 3745.1 3215.9
- Other operating expenses 330.1 294.2
- Depreciation and amortization 549.3 467.2
- General and administrative 456.0 489.2
- Restructuring charges 266.9 0.0
+ Income from non-consolidated
subsidiaries (deemed operating) 113.6 108.0
Operating income 503.9 1053.9
+ Amortization of intangibles 1.6 0.9 (a)
+ Goodwill impairment 0 0
+ Implied lease interest 237.0 208.0
NOP 742.5 1262.8
- Operating cash taxes 355.1 503.4 (d)
NOPLAT 387.4 759.4

Non-operating expense (income), net:
Interest income and other, net -9.0 -40.4
+ Interest expense 53.4 38.0
+ Income from non-consolidated
subsidiaries (non-operating) -0.0 -0.0
Non-operating expense, net 44.4 -2.4
* Marginal tax rate 37.8% 38.4%
Tax on non-op expense, net 16.8 -0.9 (b)
After tax non-op expense, net 27.6 -1.5 (c)

Operating taxes:
Reported taxes 144.0 383.7
+ Tax on non-op expense, net 16.8 -0.9 (b)
+ Tax on lease interest 89.6 79.9
Operating taxes 250.4 462.7
- Increase in deferred tax (e)
liability -104.7 -40.7
Operating cash taxes 355.1 503.4 (d)

Net income 315.5 672.6
+ Increase in deferred tax liab -104.7 -40.7 (e)
+ Goodwill impairment 0.0 0.0
+ Amortization of intangibles 1.6 0.9
+ After tax non-op expense, net 27.6 -1.5 (c)
+ After tax lease interest 147.4 128.1
NOPLAT 387.4 759.4

Finally, ROIC:
OK, our two NOPLAT calculations match up! Sweet. Now to calculate ROIC. We can either use the prior year's IC to calculate current year ROIC, as that's the capital the company had available coming into the year, or we can average prior and current year's IC, smoothing out effects of capital changes such as stock buybacks and newly issued debt. The latter approach seems to be a bit more conservative in Starbucks' case, so we'll use that.

2008 2007 2006 2005
Avg IC 7195.2 6315.3 5024.7 4129.2
NOPLAT 387.4 759.4 640.4 538.2
ROIC 5.4% 12.0% 12.7% 13.0%
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