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Subject:  Simplifying ROIC Date:  2/11/2002  9:53 PM
Author:  Chinwhisker Number:  6912 of 46978

Hi FC,

It took a while for me to get a grasp on ROIC, so I thought I might offer up a more simple look at the formula used in calculating ROIC and the ROIC-WACC spread so that others could have a better understanding of what was going on before reading through Dale Wefflaufer's excellent "A Look at ROIC" here

Hopefully from reading through the discussions, and the comparisons Pierre offered, we can all see how ROIC helped to show how Medco was a drain on invested capital for Merck. By ridding themselves of the lower margin, capital intensive business of Medco, Merck will be able to turn around their business and offer us a chance to catch a great company at a bargain-basement price.

Return on Invested Capital (ROIC) takes the ratio of ROE and Amortization adjusted ROE to a bit higher level of considering all invested capital as opposed to just equity by also taking into consideration the debt a company keeps on it's balance sheet as well.

After reading through Dale's and others explanations, I tried to reduce the formula to an easier to understand calculation. I thought by making it simpler, we could use it in our company reports.

For ROIC and ROIC-WACC spread, we would have this formula;

ROIC = After tax Operating Earnings / (equity + debt)

WACC = (equity / equity+debt) * discount rate + (debt/equity+debt) * (1-tax rate)

* = times

/ = divide

+ = plus

- = minus

That's it! What you think? :o)

For explantion purposes;

After tax operating earnings = Net Operating Profits After Taxes (NOPAT)

NOPAT equals:

Start with:
+ Reported Net Income

Add back:
+ Goodwill amortization
+ Non-recurring costs
+ Interest expense
+ Tax paid on investment and interest income (effective tax rate X investment income)

- Investment and interest income
- Tax shield from interest expenses (effective tax rate X interest expense)


Invested Capital equals:

Start with:
+ Total assets

- Cash, S-T investments and L-T investments (excluding investments in strategic alliances)
- NIBCLs (non-interest-bearing current liabilities)

I just simplified it to equity + liabilities minus investments and NIBCLs -or- equity + debt.

For WACC, it gets a little more complicated. You wanted WACC adressed as a percentage and what I did accomplishes this and simplifies it. Dale's was the most simple explanation I have found, but still not that easy to decipher. You can read his explanation in the "Equity Isn't Free" (part 5) from "A Look at ROIC"

Hope this is not too far off base.

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