John Emerson

Investing Sabermetrics: CROIC

June 16, 2012 | About:

Two roads diverged in a wood, and I, I took the one less traveled by, and that has made all the difference. ------ Robert Frost

Sabermetrics could be described as the detailed study and analysis of the efficiency level of a baseball player’s performance. The analysis relies upon observational data as well as recorded statistics. For instance, instead of using a traditional measure of a batter's efficiency such as his batting average (hits divided by at bats), sabermetrics prefers to measure on-base-percentage (OBP) which is derived by adding walks and the times a player is hit by a pitch into the formula. In calculating a traditional batting average, those two entities are deemed to be neutral. In other words they do not count as an official at bat.

OBP is considered to be a more pertinent statistic than batting average since the more times a batter reaches base, the more likely it becomes that he will record a run. Therefore, a player's ultimate efficiency and subsequent value in generating runs is better depicted than by his OBP rather than his batting average. Using the aforementioned metric a lead off hitter who hits only .300 might actually be deemed to be slightly more valuable than one who carries a .330 batting average. Such would be the case if the .300 hitter recorded a significantly higher amount of walks than the .330 hitter.

Additionally, the .300 hitter who records a high amount of walks is likely to force the opposing pitcher to throw more pitches. Each pitch that is thrown extracts a small toil on the starting pitcher. Since relief pitchers, particularly ones that enter in the early to middle part of the game are generally inferior to the starters, forcing out the starter is likely to result in the opponent scoring more runs.

Sabermetrics will also chart the method in which a player records an out in an attempt to remove chance occurrences from performance. The idea is to identify the true underlying value of a player by meticulously scrutinizing his performance on an out by out basis.

For instance, a General Manager would prefer a batter who makes a sizable percentage of his outs by line drives as opposed to ground outs. The reason is obvious to most baseball fans; a hitter who consistently hits line drives as opposed to grounders, is going to record more hits in the course of an ordinary baseball season. Furthermore, such a player is less likely to hit into double plays, one of baseball's deadly sins.

Sabermetrics has come into the public conscience as a result of the best selling book and subsequent movie, "Moneyball" by Michael Lewis. Brad Pitt was offered the lead role of Billy Beane, the General Manager of the Oakland Athletics. Astute observers have noted a certain resemblance between my avatar and the mug of Brad Pitt; I want to go on record as stating I was never interested in portraying Billy Beane in film or dating Angelina Jolie.

Investing has its own set of sabermetrics; various formulas which can measure the performance of a business. One such formula is the Cash Return on Invested Capital (CROIC) which is a more efficient measure than ROC. Analyzing CROIC is the subject of today's discussion.

The Concept of CROIC and Its Calculation

CROIC can be defined as the amount of free cash flow (FCF) a company generates divided by its invested capital (IC). In mathematical form, the formula is FCF/IC = CROIC.

The problem with CROIC lies not in the concept, rather in its calculation. Few would argue that a company which yields low returns on its invested capital is equivalent to one that yields higher ones. However, higher returns are sometimes merely a function of the calculation process.

For instance, if I choose to calculate my FCF measure by including changes in working capital, I might be exaggerating the true profitability of a company during periods of excessive inventory liquidation. The company may be liquidating its inventory at a discount to its cost while cash flows from operations are increasing precipitously.

The liquidation may represent a realization of value for balance sheet investors but it hardly depicts a realistic portrayal of the company's profitability. In such cases accrual earnings or preferably owner earnings rather that FCF, provide a superior metric in regard to the company's true profitability.

Additionally, accrual losses such as goodwill impairment or inventory write-downs which have no effect on statements of cash flow may or may not belie the efficiency of a business. All aging inventory which has been written-down is not created equally for different businesses. If I own an aircraft repair company my inventory write-down is much different in nature when compared to a business that sells screen-printed T-shirts.

A written-down printed T-shirt holds little in the way of intrinsic value while a written-down airplane part may or may not hold a high degree of intrinsic value. It all depends on whether the part is truly obsolete or merely obsolete from an accounting prospective. Alas, no accounting system perfectly depicts reality.

More importantly, to accurately assess the real returns on the capital of a company, goodwill impairments must be factored into the equation. If Company A purchases Company B and later impairs all the accounting goodwill in the purchase; Company A has greatly enhanced the prospects of its future returns on capital merely by writing down its prior investment.

In the above example it makes no difference whether Company A calculates its ROC by using accrual earnings or FCF since the denominator of the ROC ratio is a function of the balance sheet. Specifically, the capital which was invested to purchase Company B has magically and permanently disappeared from the balance sheet of Company A. Therefore, all future returns will be based upon a lower amount of company capital unless the cost of impaired acquisition is added back into the denominator of the ratio.

In the case of Company A, computing its ROC post-impairment is consummate to analyzing the efficiency of a batter by using only his batting average. While computing its ROIC, ( if we include the total capital invested in Company B) is consummate to utilizing on-base-percentage (OBS) to provide a more accurate portrayal of his performance.

In reality, the concept of assigning a rate of return on invested capital works much better in evaluating organic growth. However in the business world, acquisitions are quite commonplace. Ignoring their true costs severely damages the veracity of computed rates of returns.

Various methods of calculation can be used in figuring FCF and IC; however I believe the most useful method of calculation is supplied by Gurufocus contributor Jae Jun. With the caveat that investors need to add back all recent goodwill impairments into the invested capital portion of the ratio.

As Jun suggests using the concept of owner earnings as free cash flow is a preferable method of measuring company profitability since it eliminates temporary changes in working capital.

FCF = Owner earnings = Net income + depreciation & amortization +/- one-time items – capital expenditures

Invested Capital = Total Equity + Total Liabilities – Current Liabilities – Excess Cash

Where Excess Cash = Total Cash – MAX(0,Current Liabilities-Current Assets)

Excess Cash

The concept of eliminating excess cash from CROIC returns is critical in analyzing the efficiency of a company's business model. Virtually every outstanding business holds significant amounts of excess cash on their balance sheets; that fact exists whether the company pays regular dividends or not. Highly successful businesses are continually throwing cash and it becomes nearly impossible for management to rapidly reallocate the cash in an intelligent manner.

Including excess cash in calculating return rates distorts their validity to the downside. The common practice is to eliminate excess cash from return formulas by subtracting out working capital from total cash. I find the practice to be satisfactory in estimating the legitimate capital required to run the business.

Summary

1) Despite its inherent calculation problems, CROIC is a superior tool for measuring the efficiency of a business model when compared to ROE, ROC or ROIC.

2) Recent goodwill impairments should always be added back into calculations of invested capital to increase the veracity of return rates.

3) Using owner earnings as FCF in the numerator of CROIC formulas is advisable since it eliminates temporary changes in working capital which can distort the true profitability of a business.

4) Eliminating excess cash is an essential factor in calculating realistic return rates.

In the next edition of Investing Sabermetrics, I will unveil a superior method of evaluating a business for value investors who focus on the balance sheet rather than the income statement.

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

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Fkattan - 4 years ago    Report SPAM
John, thanks for the article. I believe that the calculated CROIC (as Jun suggests) is somehow inconsistent. The numerator is the cash flow that it is left to the shareholders, after paying interests on debt. The denominator is the sum of equity financing plus long term debt financing (current liabilities are sustracted). Perhaps it would be more precise to add interests to the owner earnings or to use only the equity financing in the denominator.

Thanks again and congratulations, I always read your articles.
John Emerson - 4 years ago    Report SPAM
I would have to think more about the first part of your assessment about adding back interest in the owner earnings side.

However, one could not eliminate the LT debt from the invested capital equation since the LT debt carries a real cost in the form of interest and is necessary in financing the capital needed for a business to stay operational. On the other hand, current liabilities such as accounts payable are generally interest-free loans, that is why they are excluded from invested capital formulas.

When I had my tiny remodeling business all I had to do was sign for supplies and have them delivered to the job site. So long as I paid by the 10th of the following month no interest accrued---thus they were interest-free loans that helped finance my working capital requirements. In other words, my accounts payable to the supply house required no invested capital so long as I paid them back on time. Quite different than securing a long-term, interest-bearing loan to purchase capital equipment needed for the business. That requires either equity or debt which are both invested capital.

Thank you for responding!