Preferred stock is a form of hybrid financing that has the qualities of both equity and debt. In terms of claims on assets and cash flows, preferred stock is senior to ordinary shares, but below bonds, and may have priority over ordinary shares when dividends are paid or the business is liquidated. They may also be convertible into ordinary shares. By their nature, they divert future cash flows away from shareholders, and so they must be removed from calculations of shareholder value, reducing the firm’s economic book value (EBV).
Deferred compensation is that portion of employee compensation that has been set aside for future payment. Firms create plans to manage the assets that will be used to settle these liabilities. Consequently, deferred compensation assets are a non-operating liability, which is to say that they are not part of the invested capital that is used to earn net operating profit after tax (NOPAT) for shareholders.
Firms may report its deferred compensation assets on the face of the balance sheet, which makes discovery a trivial affair, or, off the face of the balance sheet, hidden in its notes. The former requires an exegesis of the nomenclature, while the latter requires a work of excavation that analysts and investors are usually not willing to do.
Effective 2005, the IASB required employee stock options (ESO) to be expensed in the income statement, with the FASB following a year later. Until then, firms could treat ESO compensation as if it was not a cost, inflating their reported earnings. Consequently, for the era before this accounting change, one must dig up data from the footnotes in order to calculate the cost of ESO issuances and ensure that results are comparable across periods and add the charge to net income so as to arrive at a better measure of NOPAT.
Not only are ESOs a compensation effect that impacts profitability, they are also an obligation to pay employees in shares, in a process of share dilution. There are three ways to value a firm’s ESOs: using company-disclosed fair value, which may be taken at face value if one’s estimate of share price is near that underpinning the option values in the notes to the annual report; option pricing models such as Black-Scholes or more advanced binomial (lattice) models, which, under U.S. GAAP and IFRS, firms use to estimate the total value of all ESOs outstanding; and the exercise value approach, which gives a lower bound for the value of ESOs. In practice, the reported aggregate intrinsic value and the result obtained using Black-Scholes, should be within a narrow range of each other, so I usually elect to use the reported values, unless I see fit to do otherwise. I then subtract this value from my economic book value (EBV) calculation and from the present value of future cash flows in my reverse discounted cash flow (DCF) model.
Unconsolidated subsidiaries, also referred to as investments in associates, investments in affiliated companies, and equity investments, are businesses wherein a firm has a significant stake that falls short of control, which equates to a 20% to 50% stake, and as such, they come under equity method accounting.
When I determine that unconsolidated subsidiaries are non-operating, either because they are disclosed as such, with the income bundled into a non-operating line item, or because disclosure is unclear, I remove them from my calculation of invested capital.
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.
