When a company is bought, its purchase price, debts and other long-term liabilities are fully absorbed by the acquirer’s balance sheet. However, only the income it earns for its acquirer is added to the income statement. This has the effect of depressing the acquirer’s invested capital by only partially recognising the profitability of the acquired firm while fully recognising the capital invested in it.
The thing to do is to adjust invested capital so that it reflects the impact of the acquisition for only the period in which it was acquired, to align it with the “acquired” income on the income statement. Supposing a firm made an acquisition right in the middle of the year, and that acquired firm had an invested capital of $50 billion, then, only 50% of that invested capital, or $25 billion, would impact the invested capital of the acquirer. By time-weighting the acquisitions’ invested capital, the acquirer’s stewardship of that capital is only judged for the portion of the fiscal year when the acquirer was in control.
This allows me to calculate the average invested capital as,
Beginning Invested Capital + (Ending Invested Capital – Acquired Invested Capital) / 2) + Time Weighted Acquired Invested Capital
The Financial Accounting Standards Board (FASB) eliminated goodwill amortisation from 2002 and the International Accounting Standards Board (IASB) followed in 2005. Before that, goodwill, the capitalised value of the excess of purchase price over fair value of identifiable assets, required an annual charge to earnings for up to 40 years until the value of goodwill was eliminated. (Warren Buffett’s essay, “Goodwill and its Amortisation: The Rules and The Realities” in the appendix to his 1983 chairman’s letter, is an excellent discussion of goodwill amortisation). Since those accounting changes, goodwill is now subjected to impairment testing, which, unlike goodwill amortisation, is a real economic cost to the firm.
Statement of Financial Accounting Standards (SFAS) 142 has implications for my calculation of invested capital. Accumulated goodwill amortisation, which sums up all the goodwill amortisation expensed throughout the life of the firm, is added back on my calculation of invested capital, for the pre-SFAS 142 era.
Pooling of interests is another long-defunct accounting method impacting goodwill. Prior to SFAS 141, which came into effect in 2002, when companies using this method merged, or acquired a business, the assets and liabilities of the company acquired or merged with were transferred at their book values, avoiding goodwill recognition and recording of the purchase price, eliminating the need for goodwill amortisation, and so, inflating GAAP earnings. In addition, because book values were typically lower than the purchase price, a firm’s balance sheet was more attractive, as were its returns. So, to ensure comparability between firms using the pooling of interests method and the purchase method of accounting for mergers and acquisitions, for companies using the pooling of interests method, I add the difference between what the firm paid for the business and the book value of assets, to invested capital.
Firms use a portion of their cash and cash equivalents and investments as operating cash for the running of the business, and any cash beyond this amount is excess cash and a non-operating asset. As a rule of thumb, I assume that operating cash is equal to 5% of revenue, increasing or decreasing this requirement according to the firm’s operating profitability. Excess cash grants firms optionality, and protection against crisis, and, compounds as a consequence of a firm’s profitability. As a non-operating asset, excess cash is not part of my calculation of invested capital. In the last twelve months (2Q 2023 to 1Q 2024), Meta Platforms had $61.48 billion in excess cash, assuming that, given the company’s profitability, operating cash is 2% of revenue.
This Statement improves financial reporting by requiring an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income of a business entity or changes in unrestricted net assets of a not-for-profit organization. This Statement also improves financial reporting by requiring an employer to measure the funded status of a plan as of the date of its year-end statement of financial position, with limited exceptions.
When retirement-related assets and liabilities are too small to disclose on the face of the balance sheet, companies will often elect to include prepaid pension assets within long-term assets and unfunded pension liabilities in other long-term liabilities, disclosing the details in the notes. For example, W.K. Kellogg, in its 2023 10-K, provided the details of its retirement-related assets and liabilities in note 9, “Pension and Post-Retirement Benefits”, starting on page 70. In 2023, the company had around $1.1 billion in pension and post-retirement benefits, against plan assets valued at $1.24 billion, for a net funded status of $145 billion.
The $145 million in excess funds tied up in the plan assets are given the same treatment as excess cash and do not form a part of the invested capital calculation. Instead, that $145 million is dedicated from my invested capital calculation, because it is not needed to generate any returns, it is dead capital. On the other hand, underfunded plans are effectively borrowings from the employees, and do not require any adjustments to invested capital calculation.
Deferred tax accounts arise because of differences in how firms and the government account for taxes. For example, whereas the government uses accelerated depreciation to calculate taxes owed, firms employ straight-line depreciation. The taxes the company will actually pay, its “cash taxes”, will be lower than the tax expense or provision for income taxes that it will report.
When the business’ reported income is less than its taxable income, the firm generates deferred tax assets (DTAs), whereas when its reported income is greater than its taxable income, deferred tax liabilities (DTLs) are created. They are either reported on the face of the balance sheet, or off its face, hidden away in the notes. DTAs increase a firm’s reported assets, whereas, DTLs can be seen as a kind of interest-free debt. In 1996, Warren Buffett remarked that,
“Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own more assets than our equity capital alone would permit: deferred taxes and “float”… In effect, they give us the benefit of debt – an ability to have more assets working for us – but saddle us with none of its drawbacks.” This is because they are a portion of reported taxes that the business will pay in the future, and, therefore, can deploy in other ways in the interim.
The chart below shows Meta Platforms’ DTAs, net of DTLs, from 2011 2023, with the firm reporting DTAs such as share-based compensation, accrued liabilities, and loss carryforwards, and DTLs such as depreciation and amortisation, and right-of-use assets.
The impact of DTAs and DTLs is removed from my calculation of invested capital, because DTLs are a financing account, and DTAs are not representative of the historical capital invested into the business by the shareholders. This is done by subtracting DTAs from invested capital and including DTLs. In my reverse discounted cash flow (DCF) models, I deduct DTLs net of DTAs to arrive at the market’s implied valuation of a business.
Asset write-downs occur when the fair value of an asset, what it would fetch on the market, falls below its carrying value, the cost of an asset less accumulated depreciation or amortisation, forcing the book value, what appears on the balance sheet, to be written down, perhaps even completely, to its fair value. Write-downs and write-offs are important signals to debt investors of the deteriorating quality of collateral, but in sending those signals, they muffle another: the historical invested capital put into the business by its shareholders. So, a firm’s return on invested capital (ROIC) rises because invested capital, the denominator in ROIC, is shrunk after a write-down. In effect, this penalises firms with no write-downs when compared with firms with write-downs.
To reverse the adulterating impact of asset write-downs, I add back cumulative after-tax asset write-downs to my calculation of invested capital. Given the computational difficulties of doing so for too extended a period, and the utility of doing so, I exercise some judgement to assess how far back this accumulation must go. With regards to the after-tax form of the write-downs, this is because the tax benefits of write-downs are real benefits to the business that allay the destructive impact of the write-downs.
Accumulated other comprehensive income (OCI) is a sea into which various unrecognized gains and losses are poured. In the United States, largely consists of currency adjustments, unrealized gains and losses on available for sale securities, gains and losses on derivatives held as cash flow hedges, actuarial gains and losses on defined benefit plans recognized, and changes in the revaluation surplus. For example, in its 2023 10-K filing, HF Sinclair Corp. reported an accumulated other comprehensive loss of $11.78 million, whose breakdown is given on page 122:
IFRS also recognised an accumulated OCI account within shareholder’s equity, although each reserve is reported separately.
It is obvious that the nature of the items within the accumulated OCI are both volatile and not immediately available for deployment by management. Therefore, accumulated OCI is removed from my calculation of invested capital. A note must be made of the impact of the Financial Accounting Standard Board’s (FASB) Accounting Standards Update (ASU) 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities,”which was voted in in 2016 and came into effect in 2018. Warren Buffett excoriated the update in his 2017 letter to Berkshire Hathaway’s shareholders, saying,
Berkshire’s gain in net worth during 2017 was $65.3 billion, which increased the per-share book value of both our Class A and Class B stock by 23%. Over the last 53 years (that is, since present management took over), per- share book value has grown from $19 to $211,750, a rate of 19.1% compounded annually.*
The format of that opening paragraph has been standard for 30 years. But 2017 was far from standard: A large portion of our gain did not come from anything we accomplished at Berkshire.
The $65 billion gain is nonetheless real – rest assured of that. But only $36 billion came from Berkshire’s operations. The remaining $29 billion was delivered to us in December when Congress rewrote the U.S. Tax Code. (Details of Berkshire’s tax-related gain appear on page K-32 and pages K-89 – K-90.)
After stating those fiscal facts, I would prefer to turn immediately to discussing Berkshire’s operations. But, in still another interruption, I must first tell you about a new accounting rule – a generally accepted accounting principle (GAAP) – that in future quarterly and annual reports will severely distort Berkshire’s net income figures and very often mislead commentators and investors.The new rule says that the net change in unrealized investment gains and losses in stocks we hold must be included in all net income figures we report to you. That requirement will produce some truly wild and capricious swings in our GAAP bottom-line. Berkshire owns $170 billion of marketable stocks (not including our shares of Kraft Heinz), and the value of these holdings can easily swing by $10 billion or more within a quarterly reporting period. Including gyrations of that magnitude in reported net income will swamp the truly important numbers that describe our operating performance. For analytical purposes, Berkshire’s “bottom-line” will be useless.
Before the update, firms could class equity securities as either trading securities, available-for-sale securities, or cost-method securities. Changes in the fair value of trading securities were recognised through net income, while those of available-for-sale-securities were recognised in OCI, with dividends recognised through net income. Cost-method securities, which had no easily determinable fair value, were reported at cost minus impairment, with dividends and impairment losses recognised in net income. Under the update, equity securities are now all be measured at fair value through earnings and classed as equity investments, or as equity investments accounted for using the equity method. Where equity investments are not part of a firm’s consolidated financials or accounted for under the equity method, firms will have to either recognise changes in fair value through net income, or at cost, minus impairment, and plus or minus subsequent adjustments for observable price changes, with changes in the basis of these investments ported in the firm’s current earnings. The import of this is to treat equity securities as if they were all trading securities under the ancien régime, except for those without readily determinable fair values, which are accounted for under the modified cost method. The fair values are, nevertheless, adjusted to reflect observable price changes in similar equity investments.
Non-financial companies disclose unrealised gains and losses from equity investments under “Other income (expense) on the income statement, while financial companies disclose them in the notes to the financial statements. “Other income (expense) does not form part of my calculation of NOPAT, so, for post-2018 results, there is no impact on my treatment of the income statement. Because financial companies disclose unrealised gains and losses in more idiosyncratic ways, changes have to be made by first going through the notes and finding them.
Because unrealised gains and losses are now recognised through net income, accumulated OCI is artificially decreased, affecting my calculation of invested capital. Under the old rules, the fair value was reported on the balance sheet and the cost basis, the capital deployed to make the investments, was disclosed in the notes, along with the fair value and net unrealised gains and losses of their equity investments. To reflect the cost of the equity investments, one merely had to deduct the accumulated OCI from fixed assets. With ASU 2016-01, unrealised gains and losses are no longer in accumulated OCI. Where firms disclose the cost basis, fair value and net unrealised gains and losses of their equity investments, I can recalculate accumulated OCI under the old rules, adding back the cumulative net unrealised gains and losses to accumulated OCI, net of taxes and minority interests, which allows for more consistency in treatment of both accumulated OCI and fixed assets. However, this is not always the case. Without quarterly reporting of these components, I have to add the incremental unrealised gains and losses through the reporting periods, net of estimated taxes, minority interests and gains on sale of equity securities, to the prior net unrealised gains and losses figure, to try and ape how accumulated OCI was formed under the old rules.
Under both IFRS and US GAAP, assets and liabilities held for sale are reported separately on the balance sheet and their income and loss from them, or the result of their sale, are reported as discontinued operations separate from continuing operations.
The logic of discontinued operations is that they are not a component of core operations and therefore, not only do their earnings not belong in a calculation of net operating profit after tax (NOPAT), they also do not belong in a calculation of the invested capital that generates NOPAT. So, I banish them from my calculation of invested capital.
Companies create reserves in anticipation of probable future costs or losses whose amounts can be reasonably estimated, as happens with inventory reserves and loan-loss provisions, or, in order to ensure comparability across accounting methods as happens with LIFO reserves.
While operational excellence should be the lodestar guiding managers, there is a great temptation to use reserves to manage earnings. In order to ward off the effects of earnings management, ensure comparability across business, and reveal timing of recurring cash flows from operations, the change in LIFO reserves, other inventory reserves and loan loss reserves year-over-year are added to my calculation of net operating profit after tax (NOPAT).
The worries expressed in my short note on the change in reserves, pertain to the balance sheet as well, with managers well capable of adulterating asset values through the innocent exercise of the discretion that the rules allow. Reserves are added back to assets as part of my invested capital calculation.
Taxes incorporate operating, non-operating and financing items. One wants to assess the core operations of a business, free of any financing effects, in order to estimate net operating profits after tax (NOPAT), and so, one must break off operating taxes, from taxes on non-operating accounts, and other non-operating taxes. This gives us the taxes the firm would pay if it only engaged in its core activities and was wholly equity financed.
I start with reported provision for income taxes or income tax expense, and then subtract the change in the deferred tax account in order to convert taxes from an accrual to cash basis. When a company pays less in cash taxes than it reports in book taxes, it earns a deferred tax liability, a source of cash, and when it pays more in cash taxes than it reports in book taxes, it earns a deferred tax asset, a use of cash. The deferred tax account can be found on the balance sheet, but when they are not separately detailed, the relevant information can be found in the cash flow statement under the “Cash flows from the operating activities” section, as part of the adjustments to reconcile net income to net cash provided by operating activities; or, it can be found in the footnotes.
Then, I unlever cash taxes by adding back the debt tax shield from from net interest expense and operating, variable and not-yet commenced leases. This is done by multiplying the debt expense by the marginal tax rate, and adding the sum to cash taxes. Finally, I reverse the impact other non-operating accounts. Where there is information on tax benefit of non-operating items, with pre and post-tax values given, I reverse the impact of that as well. This process gives us an estimate of cash operating taxes.
This whole process can be seen in the example below in which I calculate Diamond Hill’s cash operating taxes.
