Calculating ROIC and Capital Employed: Financial Analysis and DCF Model in Python
Calculating ROIC and Capital Employed: Financial Analysis and DCF Model in Python
In The Little Book of Valuation by Aswath Damodaran, the reinvestment rate is a key concept used to estimate a firm’s growth potential. It refers to the proportion of earnings that a company reinvests back into its operations instead of distributing as dividends. This reinvestment drives future growth by funding projects, acquisitions, or other investments.
In this blog post, I will explore the concept of the reinvestment rate, demonstrate how to calculate it using real company data, and show how I incorporate it into my Discounted Cash Flow (DCF) model within a Python script. The complete script will be available in the GitHub repository linked above.
The reinvestment rate is typically expressed as:
\[\text{Reinvestment Rate} = \frac{\text{Net Capital Expenditures + Change in Working Capital}}{\text{Net Income}}\]Alternatively, for overall firm analysis:
\[\text{Reinvestment Rate (Firm)} = \frac{\text{Net Capital Expenditures + Change in Working Capital + Debt Repayment}}{\text{Operating Income (EBIT) (1 - Tax Rate)}}\]Change in Working Capital
Change in Working Capital refers to the difference in a company’s net working capital between two accounting periods. Net working capital is calculated as current assets minus current liabilities. This metric indicates how efficiently a company manages its short-term assets and liabilities to support its operations.
\[\text{Change in Working Capital} = (\text{Current Assets}_{\text{end}} - \text{Current Liabilities}_{\text{end}}) - (\text{Current Assets}_{\text{beginning}} - \text{Current Liabilities}_{\text{beginning}})\]A positive change in working capital occurs when a company’s current assets grow more than its current liabilities.
Implications:
- The company has increased its short-term resources, such as inventory or accounts receivable, relative to its short-term obligations.
- While this indicates growth in assets, it often ties up cash in operations, as funds may be used to support inventory or provide credit to customers.
For example, if accounts receivable increase significantly, it may indicate strong sales but also a delay in cash collection from customers.
A negative change occurs when a company’s current liabilities grow more than its current assets.
Implications:
- The company is using its short-term liabilities to finance operations, which could free up cash for other uses (e.g., investing or debt repayment).
- However, it may also signal potential liquidity issues if the company struggles to meet its short-term obligations.
For example, if accounts payable increase substantially, the company may be delaying payments to suppliers, freeing up cash but potentially straining supplier relationships.
Why Is Change in Working Capital Added to Net Capital Expenditures?
When estimating a firm’s reinvestment rate, both Net Capital Expenditures (CapEx) and Change in Working Capital are considered because they represent the total investment a company makes to sustain and grow its operations.
- Net Capital Expenditures (CapEx): Reflects long-term investments in fixed assets (e.g., equipment, facilities). These are investments in the company’s productive capacity for future growth.
- Change in Working Capital (ΔWC): Represents short-term investments in operational resources (e.g., inventory, receivables, payables). These are necessary to support day-to-day activities as the company grows.
Example Using Cal-Maine Foods (Ticker: CALM) for Fiscal Year 2023
To calculate the change in working capital for Cal-Maine Foods for the fiscal year 2023, we need the current assets and current liabilities at the beginning and end of the period. These figures are typically found in the company’s balance sheets from the annual reports.
Let us calculate the reinvestment rate using the given financial data. The reinvestment rate reflects how much of a company’s earnings are reinvested into its operations.
Reinvestment Rate Calculation: Step-by-Step Guide
Given Data:
Beginning of Period:
- Current Assets: \(661,519 \, \text{US\$}\)
- Current Liabilities: \(184,674 \, \text{US\$}\)
End of Period:
- Current Assets: \(1,124,925 \, \text{US\$}\)
- Current Liabilities: \(182,731 \, \text{US\$}\)
- CAPEX: \(136,569 \, \text{US\$}\)
Net Income: \(758,024 \, \text{US\$}\)
- Net Working Capital (NWC)
Beginning of Period:
\[\text{NWC}_{\text{beginning}} = \text{Current Assets}_{\text{beginning}} - \text{Current Liabilities}_{\text{beginning}}\] \[\text{NWC}_{\text{beginning}} = 661,519 - 184,674 = 476,845 \, \text{US\$}\]End of Period:
\[\text{NWC}_{\text{ending}} = \text{Current Assets}_{\text{ending}} - \text{Current Liabilities}_{\text{ending}}\] \[\text{NWC}_{\text{ending}} = 1,124,925 - 182,731 = 942,194 \, \text{US\$}\]
- Change in Working Capital (ΔWC)
- Total Reinvestment:
- Using only the CAPEX from the end of the period: \(\text{Reinvestment Amount} = \text{CAPEX}_{\text{end}} + \Delta \text{WC}\) \(\text{Reinvestment Amount} = 136,569 + 465,349 = 601,918 \, \text{US\$}\)
- Reinvestment Rate:
- The reinvestment rate is the ratio of total reinvestment to net income: \(\text{Reinvestment Rate} = \frac{\text{Reinvestment Amount}}{\text{Net Income}}\) \(\text{Reinvestment Rate} = \frac{601,918}{758,024} \approx 0.7938 \, \text{or} \, 79.38\%\)
Final Results
- Net Working Capital (Beginning): \(476,845 \, \text{US\$}\)
- Net Working Capital (End): \(942,194 \, \text{US\$}\)
- Change in Working Capital: \(465,349 \, \text{US\$}\)
- CAPEX (End of Period): \(136,569 \, \text{US\$}\)
- Reinvestment Rate: \(79.38\%\)
The calculated reinvestment rate of 79.38% indicates that the company reinvested a substantial portion of its earnings into operations and capital expenditure during the period. This high reinvestment rate reflects a focus on growth and sustaining operations.
Let us calculate the Capital Employed, Average Capital Employed, and Return on Invested Capital (ROIC) for the years 2022 and 2023.
ROIC Calculation: Capital Employed and Return on Invested Capital
Given Data:
For 2023:
- Total Assets: \(1,954,525 \, \text{US\$}\)
- Current Liabilities: \(182,731 \, \text{US\$}\)
- EBIT: \(998,550 \, \text{US\$}\)
- Tax Rate: \(24\%\)
For 2022:
- Total Assets: \(1,427,489 \, \text{US\$}\)
- Current Liabilities: \(184,674 \, \text{US\$}\)
- Capital Employed (2022 and 2023)
Capital Employed is calculated as:
\[\text{Capital Employed} = \text{Total Assets} - \text{Current Liabilities}\]For 2023:
\[\text{Capital Employed}_{2023} = 1,954,525 - 182,731 = 1,771,794 \, \text{US\$}\]For 2022:
\[\text{Capital Employed}_{2022} = 1,427,489 - 184,674 = 1,242,815 \, \text{US\$}\]
- Average Capital Employed
The average capital employed is the average of the capital employed for 2022 and 2023:
\[\text{Avg. Capital Employed} = \frac{\text{Capital Employed}_{2023} + \text{Capital Employed}_{2022}}{2}\] \[\text{Avg. Capital Employed} = \frac{1,771,794 + 1,242,815}{2} = 1,507,305 \, \text{US\$}\]- ROIC (Return on Invested Capital)
ROIC is calculated as:
\[\text{ROIC} = \frac{\text{NOPAT}}{\text{Average Capital Employed}}\]where NOPAT (Net Operating Profit After Taxes) is calculated as:
\[\text{NOPAT} = \text{EBIT} \times (1 - \text{Tax Rate})\]Using the EBIT for 2023, we calculate the ROIC:
\[\text{NOPAT} = 998,550 \times (1 - 0.24) = 998,550 \times 0.76 = 758,028\] \[\text{ROIC} = \frac{758,028}{1,507,305} \approx 0.503 \, \text{or} \, 50.3\%\]Final Results:
- Capital Employed (2023): \(1,771,794 \, \text{US\$}\)
- Capital Employed (2022): \(1,242,815 \, \text{US\$}\)
- Average Capital Employed: \(1,507,305 \, \text{US\$}\)
- ROIC: \(50.3\%\)
The ROIC of 50.3% for the year 2023 reflects a highly efficient use of capital, demonstrating that the company generates a strong return relative to its capital employed. It represents the return that the company is earning on the capital it has invested in its business (both equity and debt).
Role in Valuation
The reinvestment rate is combined with the return on invested capital (ROIC) or the return on equity (ROE) to estimate the firm’s growth rate:
\[\text{Growth Rate} = \text{Reinvestment Rate} \times \text{Return on Invested Capital}\]I am using ROIC instead of ROC (Return on Capital), since ROIC focuses on Capital Employed, that is capital that the company is actively using for its day-to-day operations and excludes assets that are not directly contributing to business activities whereas ROC typically focuses on the return generated relative to the total funds available.
In essence, the formula shows that the growth rate is a function of both how much of its earnings the company is putting back into its business and how effective those reinvestments are in generating returns. Since ROIC determines how effectively the reinvested money is being used, if the company is able to generate high returns on invested capital, each dollar reinvested will yield a higher profit, leading to more growth. Intuitively, If a company reinvests a lot of its earnings (high reinvestment rate) and is also very efficient at using those reinvested funds (high ROIC), the company can experience a high growth rate.
Given the values:
- Reinvestment Rate = 79.38% = 0.7938
- ROIC = 50.3% = 0.503
We can now calculate the growth rate:
\[\text{Growth Rate} = 0.7938 \times 0.503 = 0.399 \, \text{or} \, 39.9\%\]The calculated growth rate is approximately 40%, indicating a strong potential for the company’s growth based on its reinvestment rate and return on invested capital (ROIC). This high growth rate suggests that the company is efficiently reinvesting its earnings into high-return projects.
Incorporating ROIC, Reinvestment Rate, and Growth Rate into a Python-Powered DCF Model
In this section, we bring together all the financial concepts and calculations discussed above — from the Reinvestment Rate, ROIC, and Growth Rate to the Capital Employed — and integrate them into a comprehensive Discounted Cash Flow (DCF) model built using Python.
The goal of these calculations is to determine the Free Cash Flow to Equity (FCFE) and a sustainable growth rate. These two components form the foundation for forecasting the FCFE over the next 10 years, which is a critical input for our valuation model.
Our Python script not only automates these calculations but also generates a detailed and user-friendly HTML report that can be viewed in your browser. This report breaks down every step of the DCF process, including:
- Forecasting Free Cash Flows for 10 years using the calculated growth rate.
- Discounting these cash flows to their present value using an appropriate discount rate.
- Calculating the Terminal Value, representing the value of cash flows beyond the forecast period.
- A step-by-step DCF walkthrough, complete with intermediate values and final valuation output.
By incorporating the reinvestment rate and ROIC, our DCF model ensures that the projected growth of FCFE is grounded in the company’s operational efficiency and realistic capital deployment. This approach ensures a robust and transparent valuation process.
The report will also include a calculated fair value for the company’s stock price, derived from the projected Free Cash Flow to Equity (FCFE) and the assumptions we’ve incorporated, such as the growth rate and discount rate. While the DCF methodology we use is thorough, I won’t delve into the details of the DCF process itself, as it follows the standard framework found in any valuation textbook. Instead, the focus here is on how we automate and streamline the calculation in Python. Without further ado, here is the full Python script.