Thanks Alex for sharing your perspective on building financial models !! Can you please explain how ROIC is factored in to these models ? Is it during the business selection itself ?
Hi Balaji - Yes, that is more in the business selection itself. As it relates to modeling, my focus is on ROIIC (return on incremental invested capital), which shows up in the top-line / bottom-line growth expectations, the capital needs to fund that growth, and the ability to do things like repurchases and dividends. Hope that helps!
Can ROIIC be quantified? The denominator can be calculated using changes in working capital and capital expenditure items in the cash flow statement. What about the numerator?
Yes, it can be quantified. The most sensible way I've seen for running that calculation is to do so on a rolling 3-year or 5-year basis (reduce a lot of the noise). Of course, historic ROIIC's will only be so useful in predicting future ROIIC's, but they're a reasonable starting point. As with all things that can be quantified, I think the specificity of the output / calculation should be treated accordingly ("roughly right" is good enough). I hope that answers your question!
Hi Alex, thank you for this piece of advice! Do you have some recommendations on books/leaflets about constructing those models? I would like to learn more!
That's a great question - unfortunately, I don't have a great answer. There are books like "Valuation: Measuring and Managing the Value of Companies" that are worth reading. At the same time, I think this exercise should be approached with a fair amount of caution; you don't want to get overly impressed by the numbers. A good way to start / practice is to build a hypothetical model for a relative simple business to understand (say a food retailer). What are the variables that feed into revenue growth? What is the "cost" of those different variables (new units will require CapEx, same store sales will require working capital, etc.)? As you do that, I think you'll get a sense for how the financial statements tie together, even if just at a high level. I wish I had something more direct to recommend, but that's the path I took over the past ~15 years.
Please let me know if I can be of any additional help Radu.
Thanks Alex for sharing your perspective on building financial models !! Can you please explain how ROIC is factored in to these models ? Is it during the business selection itself ?
Hi Balaji - Yes, that is more in the business selection itself. As it relates to modeling, my focus is on ROIIC (return on incremental invested capital), which shows up in the top-line / bottom-line growth expectations, the capital needs to fund that growth, and the ability to do things like repurchases and dividends. Hope that helps!
Can ROIIC be quantified? The denominator can be calculated using changes in working capital and capital expenditure items in the cash flow statement. What about the numerator?
Yes, it can be quantified. The most sensible way I've seen for running that calculation is to do so on a rolling 3-year or 5-year basis (reduce a lot of the noise). Of course, historic ROIIC's will only be so useful in predicting future ROIIC's, but they're a reasonable starting point. As with all things that can be quantified, I think the specificity of the output / calculation should be treated accordingly ("roughly right" is good enough). I hope that answers your question!
- Alex
Thank you for your response. I have found an explanation of ROIIC on the SEC website.
i believe this method of calculation aligns better with my understanding:
Return on Incremental Invested Capital (ROIIC) = (NOPAT t=2 – NOPAT t=1) ÷ (Invested Capital t=1 – Invested Capital t=0),
Hi Alex, thank you for this piece of advice! Do you have some recommendations on books/leaflets about constructing those models? I would like to learn more!
Radu,
That's a great question - unfortunately, I don't have a great answer. There are books like "Valuation: Measuring and Managing the Value of Companies" that are worth reading. At the same time, I think this exercise should be approached with a fair amount of caution; you don't want to get overly impressed by the numbers. A good way to start / practice is to build a hypothetical model for a relative simple business to understand (say a food retailer). What are the variables that feed into revenue growth? What is the "cost" of those different variables (new units will require CapEx, same store sales will require working capital, etc.)? As you do that, I think you'll get a sense for how the financial statements tie together, even if just at a high level. I wish I had something more direct to recommend, but that's the path I took over the past ~15 years.
Please let me know if I can be of any additional help Radu.
- Alex