The Business of Value Investing.pdf

118 The Business of Value Investing

the performance of book value per share. Book value per share is

affected by changes in three categories: a change in assets, a change

in liabilities, or a change in the number of shares outstanding. All

three factors are at the complete discretion of management. While

stock price performance and book value performance might not

behave similarly in the short run, a long - term pattern of increasing

book value ultimately will be followed by a similar performance from

the stock price.

Great Managers Focus on Return on Invested Capital

Value creation is simple to understand in the context of a business.

If the business is investing its capital in projects that generate rates

of return that exceed the cost of that capital, value is being created.

It ’ s no good if a company is earning 8 percent on its invested capi-

tal if the cost of capital is 10 percent.

A common defi nition for return on invested capital (ROIC)

is the net after - tax operating profi t divided by invested capital.

Operating income, or operating revenue minus operating expense,

is the purest form of judging a business ’ s results. Operating income

strips out nonrecurring items and interest costs, which (excluding

those of fi nancial service fi rms) don ’ t have much to do with the

actual business itself. The formula for the return is:

( 1 – tax rate )  ( earning before interest and taxes )

Invested capital (IC), as you would imagine, measures how

much capital a company has invested in its business. Although there

are many different ways of measuring IC, a generally sound way of

calculating is:

( total assets – cash ) – ( noninterest-bearing current liabilities )

Basically, this equation says that the capital invested is the sum

of all the assets, and subtracts out the assets that haven ’ t yet been

invested (cash and cash equivalents). Noninterest - bearing current

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