It’s a lot easier to be consistent with any investment strategy (or any thing, period) if it’s something you truly believe in. Some believe strongly in making bets on emerging companies, going long the odds of as-yet-unknown firms becoming the next Googles and Amazons of the world—this strategy is common in venture capital, and has a small chance of very great success.
Others take a show-me-first approach to finding good investments. Warren Buffett, a well-known value investor (to say the least!) has made it a point to invest in companies only when he can grasp the underlying business model. This has caused him to miss a few home runs in big tech, but has also prevented plenty of swings and misses. As the Oracle of Omaha put it: “If a business has a great future but doesn’t have a good past, I’m going to miss it.” Buy good companies at reasonable prices.
To apply this strategy, we must have some opinion on the quality of any given business—what makes it good? The best way to answer this question is to think like an owner; an owner is someone whose livelihood is dependent upon the long-term performance of their business.
This post is first in a series examining what makes a good business, and by extension, a good investment. In this post, we take a look at the accounting underlying a basic understanding of businesses. Accounting is, after all, the language of business. If you’re already familiar with this, don’t want to review it, or just aren’t in the mood for any math, skip to the second post. That said, if we want to evaluate companies, we’re going to have to get into some numbers.
Ingredients of Business: Kroger Co.
Lemonade stands are an oft-cited example of how the structure of a business works. It’s easy to think of in conceptual terms, but it loses its simplicity when trying to translate it into the language of business: accounting. To avoid this, we’re going to jump into a more complicated real-world example, with the intent to understand the accounting as we go and relate it to the underlying business concepts.
Our example is The Kroger Company, a U.S.-based chain of grocery retail stores bearing several brands (Kroger, Ralph’s, and Fred Meyer are just a few of their storefronts). We of course know a little bit about how grocery stores work: trucks come in bearing wholesale goods—cereal from Kellogg’s, soft drinks from Coca-Cola—and people pay retail prices for the same products. Buying something and selling it for more practically defines the retail-wholesale spread, and this is how Kroger makes its money. But is it a good business? Let’s look at a few numbers—but bear in mind that this isn’t intended to be a comprehensive tutorial on what to look for in evaluating financial statements. That will have to wait.
All the numbers we look at here are from Kroger’s latest 10-K, an annual document filed with regulators to provide financial and operating information about the business. This information is publicly available for any listed stock in the United States. We’ll start with a quick glance at the income statement.
The financial statements can give us a lot of information, but for now I’ve highlighted some key areas in red. Sales are obviously important: no company can survive for long without bringing in revenues. Kroger brought in nearly $150 billion in 2022.
A quick glance at the operating expenses shows that merchandise costs are far and away the largest cost to Kroger—and this should make sense. This is what they’re paying to source and stock their stores. But there are other costs, too: administrative costs for back-office or corporate functions like human resources, advertising, finance/accounting, etc., as well as rent and depreciation, which we can think of as the cost of holding the assets they rent and own.
Deducting all these expenses leaves about $4.1 billion in operating profit, or 2.8% of sales. This may appear low; compared to many types of businesses, it is. We’ll come back to this metric later on.
Kroger will of course need to pay interest on its debt, as well as income taxes, and will recognize any further expenses that they consider “non-operating”—in this case, a $728 million loss on investments. (It’s relevant to consider this as a clue that the company’s managers and accountants don’t consider this item as an integral part of the core business, and therefore do not deduct it from operating income. We would expect that this treatment should remain consistent over time; that the company wouldn’t choose it call it “operating” simply if it was a gain rather than a loss, and we ought to keep a vigilant lookout for such accounting deceptions. We should also, of course, do a bit more research into what exactly these investments are and determine our own opinion on how related they are to the core business—but the details of financial statement analysis will have to wait for their own post.)
Upon deducting interest and tax expenses, Kroger is left with $2.2 billion in earnings in 2022. But we’re far from finished. We need to take a look at the balance sheet, too.
Above is an excerpt from their balance sheet, showing just the current assets on hand at the end of the last two years. In basic terms, current assets are what you need to run your business day-to-day. Inventory is a clear example: without stuff on the shelves, grocery stores don’t have anything to sell. They need to pay for this up front, before sales happen. Receivables represent goods Kroger has sold but hasn’t received payment for yet, whether from delinquent customers or from credit card sponsors. Even cash is needed to operate. Every cash register has to have coins and bills for change—even in 2023. Putting this together gets us to over $12 billion that Kroger needs to invest in working capital, simply to run their stores.
But working capital goes beyond current assets. Assets are what the company owns, liabilities are what the company owes. Here’s a look at current liabilities:
This is a little more complicated, so we’ll just focus on two areas: trade payables and accrued salaries. These should both make intuitive sense. Kroger has hundred (if not thousands) of different suppliers, each of whom likely offer Kroger some credit terms—i.e. payment due within 30 days of receiving merchandise—which amounts to short-term, interest-free loans to finance inventory. Most jobs pay every two weeks or twice a month, rather than paid for each day’s work at the end of the day—another source of financing for the company that shows up in accrued salaries. These items are both critical parts of Kroger’s day-to-day operations, but they don’t require Kroger to invest these funds; rather, they net out against the working capital assets Kroger needs to hold.
To simplify even more, just take receivables and payables. When Kroger holds receivables, they’re using their own money to finance customer purchases, even if for very short periods. When Kroger holds payables, they’re using a supplier’s money to finance their own operations. In most cases, it’s better to use other peoples’ money (most, not all!), and this gets us to Kroger’s net working capital.
When we net the payables and accrued salary expenses against the current assets, we calculate net working capital of $3.8 billion at the end of 2022, and $3.3 billion at end of 2021. But this is current accounts. Might we still be missing something important? Buildings, for instance?
Yes, believe it or not, many retailers still use buildings. These (and other key parts of the business) are non-current assets.
Kroger holds $24.7 billion in property, plant, and equipment. We’ll call it fixed assets for short, and add it to our working capital figure to get invested capital.
This calculation is intentionally simple, but the concept is incredibly important. We’ve determined that Kroger held $28.5 billion of net operating assets at the end of 2022, vs. $27.1 billion ending 2021, or an average of roughly $27.8 billion over the course of the year 2022. This is a figure we can directly compare to the $4.1 billion in operating profit we noted earlier. By taking the ratio of these numbers, we can get to return on invested capital (ROIC)—what I’ll call the single most important metric of long-term business quality.
Analyzing ROIC requires a great deal of care & discretion. In practice, we need to ensure that we’re being consistent with how we treat the numerator and denominator (i.e. if we exclude investments from our invested capital, we should exclude associated income from our operating profit), and need to look at a firm’s ROIC over the long-term to get a sense for how they perform over time.
This is important because it gives us a proxy into how a company’s investments may perform in the future. If Kroger’s performance is consistent going forward, I should expect the business to earn 11.4% on incremental capital that it invests into the business.
Bear in mind, calculating return on invested capital is not an exact science. Company filings may not always give clarity (even after scouring the footnotes) as to what should or shouldn’t be considered invested capital. And even if they did, there are multiple methods to estimate capital invested in the business.
A common (and relatively simple approach) is to base the calculation on sources of capital—the liability/equity side of the balance sheet. Per this approach, total equity plus interest-bearing debt (both short and long-term) represents total capital bestowed upon the business—by equity holders (owners) and debt holders (creditors).
In their Valuation textbook, McKinsey & Co. criticize the liability-side method on the grounds that it fails to investigate what capital is employed in the true operating business. In Kroger’s case, a hypothetical stock portfolio in which the company invests excess cash shouldn’t be treated as invested capital, since it isn’t being employed in the core business of operating stores—and likewise, any gains or losses on such a portfolio shouldn’t be included in “operating” income. I consider this approach more thorough, although it requires much more detailed analysis of financial statements and may ultimately require some assumptions, unless management can answer your questions to your satisfaction.
McKinsey’s approach is what I would call asset-side—estimating invested capital through examination of the asset side of the balance sheet—and requires investigation to determine what is and what isn’t an operating asset. At the end of the day, valuing the company as a whole will still require you to make some judgments about any non-operating assets, but separating them from the operating model of the business will serve to prevent them distorting your ROIC calculations.
While I like the thoroughness of McKinsey’s approach in theory, it can be difficult in practice, and the level of granularity you submit to should likely be decided case-by-case. Where possible, I often prefer to use a shorthand of net working capital plus net fixed assets, including intangible assets if these are meaningful. With this approach, I can consider all non-operating assets separately from the business, just as McKinsey intended. Whatever approach you decide to use, consistency is the critical factor: if you exclude assets from invested capital, you must also exclude any income or loss associated with that asset from your operating profit figure. Non-operating assets, by definition, cannot produce operating income, and vice versa.
The mention of intangible assets in the previous paragraph warrants an aside. Intangible assets often take two forms. Goodwill is the most common: it represents the cumulative premiums to book value that a company has paid to acquire other businesses over its life. In this sense, it’s simply an accounting trick to make the balance sheet “balance” if you pay $150 in cash for a business with a $100 book value; the $50 difference becomes goodwill. Again, opinions will differ on whether this should be considered invested capital. That $50 was spent to grow the business, yet the acquisition was likely a one-time transaction that won’t be repeated again, so is it relevant to the forward-looking view of the business (which is what ROIC is ultimately about anyway)?
Hearkening back to the point of consistency above, I would argue that if the revenues/profits from a major acquisition are considered “operating”, then the amount invested in them should be considered invested capital, including the goodwill. For Kroger, goodwill is around $2.9 billion in 2022.
Other intangibles are a bit more tricky. Sometimes they are related to acquisitions (in this case, it’s just giving goodwill a fancy name, saying they paid a premium to book to acquire another company’s “customer relationships” or “trademarks”). In this case, we can treat them similarly to goodwill. If they are internally generated (like a software patent the company developed), these are assets developed with a cost to the business, and should thus be included. One caveat on that front—many firms will treat R&D as a simple expense rather than an investment that finds its way onto the balance sheet. How a company accounts for this is important to understand when non-acquisition-related intangibles are significant.
In this case, we’ll go ahead and update our IC/ROIC calculations to include all of Kroger’s intangibles—assuming for simplicity that they’re all related to acquisitions Kroger has made in the past. When we do this, our invested capital increases to $32.3 billion in 2022. Our numerator—NOPAT—remains the same, as we were already implicitly including any acquired revenues/profits that Kroger reported. Our new ROIC figure therefore looks lower, down to 10.0%.
Why do the intangibles matter? If we do not expect any acquisitions from Kroger in the future (not likely, given they’re still trying to merge with Albertsons as of July 2023), we should expect forward-looking returns to be closer to our 11.4% ROIC ex-intangibles—assuming nothing changes. This is treating past acquisitions as just that: in the past, and not expected to recur at all. However, if we account for the fact that Kroger has bought companies in the past and may do so again, we can use 10.0% ROIC to estimate the impact this will have on overall returns.
Now, I’ve talked a lot about ROIC as a rough predictor of future returns in the business. This is because we use past ROIC to try and estimate what future ROIC will be. We can take the analysis a step further in thinking about growth to a company’s profits. To do this, we need to introduce two further concepts.
Incremental ROIC, or IROIC, is the return on capital invested in the most recent period. To know this with certainty, we’d take the amount of profits earned on the money invested in the business over the previous year, and divide by how much was invested in the business during that year. In practice, the calculation is often messy (since it’s impossible to isolate other factors like general industry downturns & cycles), but here’s a formula anyway.
IROIC = Change in NOPAT / Capex
What is capex, you ask? That brings us to the second thing. Every year, Kroger spends money to grow and maintain its business, but doesn’t show it in the income statement. Capital expenditures (capex for short) are found on the cash flow statement. We’ll present it here next to NOPAT for the last three years.
Comparing capex to NOPAT helps us understand the investment rate—basically the percentage of profits that a business reinvests to grow the business. If this is high, the business should grow faster, all else equal. If it is low, the business will hold on to more cash. For Kroger, we see the investment rate is very high, averaging over 100% of NOPAT. This roughly means that Kroger is reinvesting all it’s profits into growing their business.
And this brings us to our formula for growth:
Investment Rate % x Incremental ROIC % = NOPAT growth %
What does this mean for Kroger? It means that if the company is investing all (or 100%) of its NOPAT into the business, and we use 10% as a proxy for incremental ROIC, then we should expect NOPAT to grow at roughly 10%. This is merely an estimate, and these kinds of considerations work better in the long term than quarter-to-quarter or year-to-year—over which horizons cycles or seasonality can dominate/distort the actual numbers.
This also means that not all growth is created equal. A business with 50% ROIC and 10% IR should grow at ~5%, same as one with a 5% ROIC and 100% IR. But one would certainly prefer the former—because the remaining 90% of profits could be put to other uses, like returning cash to shareholders, paying down debt or (heaven forbid) doing another acquisition.
With these building blocks, we have a sense for what accounting we need to understand to evaluate a basic business. In the next post, we’ll go a step further to introduce a benchmark to measure ROIC against, and talk about sources and symptoms typical for high-ROIC businesses. We’ve built some conversational skills in the “language of business”—now it’s off to immersion school.
And lest we forget: consistency in assumptions is absolutely critical.