ROIC of an older factory is higher than ROIC of a new factory

[manuelbean]

Hi guys, whatever way we calculate ROIC, if we take the depreciated PP&E value (and all else equal) we will get better ROIC's the older the PP&E gets, right?

 

Shouldn't we use the original (or un-depreciated) value of the PP&E?

 

Thank you

[rranjan]

An interesting question.

 

True in hypothetical case where you simply not spend any new amount in PP&E forever.

 

In reality, businesses do have to keep spending on PP&E. Spending may not happen in smoth line each year. Some businesses will spend one time big amount every 5 years and some may spend every 10 years, but most will have to spend much more frequently.

 

If you buy a brand new car by paying $10,000. Assume life of car is 10 years and it becomes worthless in 10 years. It depreciates by 1K each year. In year 2, tangible capital is 9K and in year 3 , your tangible capital is 8K.

 

If you are able to not spend a single penny in car for 10 years and car keeps producing 1K earnings for you then Return on invested capital will keep increasing.

 

In reality you will have to spend on car each year and you have to spend on factory each year just to maintain it. May be you can get away for 1-2 years, but PP&E will start adding up.

 

If you are using 2 years old car then you do have use 8K rather than 10K as worth of car as invested capital after 2 years. If you try to sell the car will you get 10K in year 2? If not then you can't claim that tangibel capital deployed is 10K in year 2.

 

In some cases, depreciated amount does not reflect reality, but in general using depreciated amount makes sense if we are trying to see what our car/business is producing each year on invested capital.

 

Hope it helped.

[manuelbean]

Thank you rranjan.

 

I know what you mean and it makes some sense. But let's say that in year 3, you've spent $500 on the car. Your true invested capital is the initial $10.000 + $500 = $10.500 whereas according to the accounting rules, your Invested Capital will be $8.500 (assuming you've spent those $500 in the first month of year 3).

 

A car is something that needs a lot of maintenance, but if we're talking about a house (a properly built, solid one), it might take 20 years before you spend money on it. And on year 19, the invested capital will be much lower than the amount you have invested in the first place.

 

By the way, can you give me some examples of a case where the depreciated amount doesn't reflect reality?

 

Thank you for your help

[Hielko]

Hi guys, whatever way we calculate ROIC, if we take the depreciated PP&E value (and all else equal) we will get better ROIC's the older the PP&E gets, right?

 

Shouldn't we use the original (or un-depreciated) value of the PP&E?

 

Thank you

No. Because you are also reducing the return number of the ROIC by the depreciation. If you use the return number that contains depreciation and then asset value that doesn't you just get something weird.

 

And sure, these calculations are always imperfect. Straight line (or other method) depreciation is in the end always an accounting construct, not reality.

[Cigarbutt]

If you describe a factory with productive capacity, you may consider the perspective of a private party as a potential buyer of the asset. When running the factory (IRR or NPV point of view), you will take decisions about basic maintenance costs (typically expensed, and reducing the numerator) and about upgrades to maintain earning power (typically capitalized capital expenditures, which will affect the denominator). As the operator of the business, you may be ahead or behind schedule (owner's earnings perspective) and the buyer will look into that.

On top of the intrinsic decisions related to earning power, there are potentially extrinsic reasons that may change the fair value of the recorded asset (competitive position). If one of your competitors enters financial distress or if your factory makes face masks, all of a sudden the value recorded on the balance sheet no longer reflects the fair value.

IFRS (vs US GAAP) allows to use the revaluation method to update the fair value of assets such as factory and equipment but one is always left with the possibility that the value recorded needs an adjustment from an outsider's perspective.

Normally, in a competitive market, if you find a business that does not require cap ex to maintain earning power, it's the earning power that will tend to be at risk as more capital will tend to enter the specific market.

[DW1234]

Fundamentally this should definitely be true in some cases. ROIC in new assets could be worse than buying older assets. A taxi company only buying 2-3y old cars could have a higher ROIC than a taxi company only buying new cars. It's up to the CEO to make this capital allocation decision.

 

[wabuffo]

I don't have much to add to the ROIC/depreciated PP&E value question - except to make a couple of points about manufacturing facilities.

 

Land is land and doesn't depreciate.  Buildings do not wear out even for fifty years.  When it comes to production lines and manufacturing equipment, there is regular maintenance capital, but I would argue that production lines get replaced more likely for changes to the companies product offerings, new product introductions, or labor-savings than because of wear and tear.  Sure, things break down or new safety or environmental standards might require upgrades - but for the most part capital expenditures are made to earn a return and that requires new sources of production volume and/or incremental margins.

 

This brings me to my major point.  Here I will quote Benjamin Graham (Security Analysis, 1940 ed, Ch XXXVI):

"Factories do not actually wear out; they become obsolete.  In nine cases out of ten, plants are given up because of changes in the character of the industry or status of the corporation or locality where the plant is situated or for other reasons not related to actual depreciation.  These developments represent business hazards, the extent of which is not susceptible of any engineering or accounting measurement.

 

Stated differently, the long-term depreciation factor is in reality overshadowed and absorbed by the obsolescence hazard.  The risk is essentially an investment problem and not an accounting problem."

 

I've worked for major public manufacturing-oriented companies.  Plants are closed while they are still very functional and productive and not due to degraded equipment. They are closed because volumes are down and two plants can be consolidated into one.  In addition, I've seen companies make investing mistakes (from a shareholder return) building new plants in low-growth industries when the old plants were working just fine.

 

When I look at manufacturing companies, I adjust the concept of maintenance capital to mean, not how much capex must be invested to maintain the equipment, but rather how much must be invested to maintain the company's current production volumes and competitive position.  In some cases (particularly in the tech sector), I would even argue that acquisitions are often maintenance-related in that they cover for a declining base business and only maintain current profitability (rather than enhancing or growing it).  HP was a good example of this - the ample free cash flow kept getting plowed into acquisitions to cover for a declining core business. 

 

The point is, don't get overly focused on depreciation and ROIC as accounting questions, they need to be looked at as competitive positioning questions and factories are just assets that need to be evaluated in that context.

 

wabuffo

 

[rranjan]

Thank you rranjan.

 

I know what you mean and it makes some sense. But let's say that in year 3, you've spent $500 on the car. Your true invested capital is the initial $10.000 + $500 = $10.500 whereas according to the accounting rules, your Invested Capital will be $8.500 (assuming you've spent those $500 in the first month of year 3).

 

A car is something that needs a lot of maintenance, but if we're talking about a house (a properly built, solid one), it might take 20 years before you spend money on it. And on year 19, the invested capital will be much lower than the amount you have invested in the first place.

 

By the way, can you give me some examples of a case where the depreciated amount doesn't reflect reality?

 

Thank you for your help

 

I have seen companies depreciating buildings at fast rate and in reality they don't really depreciate that fast. Then you have accelarated depreciating schedule allowed in some cases to help companies pay less tax to simulate economy. Depreciated asset may or may not reflect the exact value of asset.

 

Some time it's just accounting figure and in reality you won't be able to get money out of asset if you try to really sell in market.

 

Going back to your car example, you did pay 10K and then spent 0.5K in year 3, making total spent money 10.5K. Still, it will be not correct to use 10.5k as tangible capital deployed in year 3 because car is not worth 10.5K in year 3. In reality car may not be worth even 8.5K, but 8.5K should be much closer to tangible value than 10.5K.

 

These straight line depreciation is simply a way to make it smooth because we know that car depreciates much faster in year 1.

 

Now if you have a business which uses cars, you will be much better off by buying 1 year old cars than buying brand new car if everyrthing else is equal. Deterioation of car is normally a lot less than market value drop in first year. In fact , real depreciation if quite a lot just after you drive out of dealer's shop after paying.

 

 

[SharperDingaan]

In the accounting world, depreciation is NOT just a expense recognizing use of the asset. Per the 'going concern' assumption - it is ALSO the amount for the period, that should have been put aside to REPLACE the asset as it wore out. Ideally, the depreciation method chosen, reflecting the expected use of the asset over time. ROIC is only meaningful when the IC is approximately MV (assets are revalued at MTM every period).

 

Buy an apartment building, and you control land AND a structure.

The structure depreciates, &/or becomes obsolete. and is demolished, Replaced with a shiny new structure reflecting highest/best use of the land, at the time of construction. The ROIC should be that of the new structure + the ROIC of the land rental, weighted by the capital invested in each. The ROIC on the old building has to be the same, or higher - were it lower, you would simply demolish and replace. Which will occur when the diminishing net rents can no longer adequately cover the rising upkeep.

 

We don't much care whether this occurs as a result of market forces (building obsolescence, declining market rents, etc), or just simply wearing out (aging windows, carpet, HVAC, plumbing, etc).

 

SD

 

[DW1234]

Wabuffo thanks for that post. Really helpful.