Annual reports are not merely long, and complex, with often abstruse language that seems calculated to befuddle the reader, they are also structured in ways that unintentionally disguise operating performance. To start with, financial statements are not designed to be particularly helpful for an investor seeking to understand the operating performance and value of a business. This is because they mix together core and ancillary business activities and transitory shocks. Income statements commingle operating income with interest expense and other non-core, non-recurring items; balance sheets mush together operating assets, non-operating assets and sources of financing; and cash flow statements blend operating cash flow with investing and financing cash flow.
“Net Operating Profit After Tax (NOPAT)”, by Joseph Noko
Invested capital is the accumulation of investments that have been made into a business’ core operations, in order to earn NOPAT. As with NOPAT, I calculate invested capital from both an operating and financing perspective, the results of which should be the same. From a financing perspective,
Invested Capital = Total debt & leases + Equity Equivalents + Common Equity
where,
Total debt & leases = Short-term debt + long-term debt + operating, variable and not-yet commenced leases
From an operating perspective,
Invested Capital = Net Working Capital + Total Adjusted Fixed Assets
where,
Net Working Capital = Operating Current Assets – Non Interest-Bearing Current Liabilities
and,
Total Adjusted Fixed Assets = Tangible Assets + Intangible Assets + Other Assets
I make a number of adjustments to strip away the impact of non-recurring and non-core items in order to unearth the true economics of a business. An example of what that looks is given in the tables below, with Diamond Hill as my subject.
Firstly, I calculate Diamond Hill’s invested capital from an operating perspective, for the years 2019 to the last twelve months (LTM) ending 2Q 2024:
This can be reconciled with the firm's total assets, as shown below:
The virtue of this approach is that it gives me an insight into the true economics of a business while being replicable, scalable and transparent.