In this presentation, David Trainer explains why invested capital is the critical denominator in the return on invested capital (ROIC) metric and outlines New Constructs' proprietary methodology for calculating a true invested capital figure. He argues that invested capital should capture all capital ever put into a business, regardless of accounting labels or financing form, and illustrates the impact of mis‑measuring it with a simple loan‑example. Trainer then details the 12 balance‑sheet adjustments New Constructs applies to SEC filings to derive a clean invested‑capital number, emphasizing that each adjustment can materially affect ROIC and, consequently, valuation judgments. The adjustments include converting operating leases to capital leases, bringing off‑balance‑sheet reserves onto the balance sheet, removing discontinued operations and accumulated other comprehensive income, adding back asset write‑downs, stripping non‑operating deferred tax items and over‑funded pension assets, excluding excess cash (and adjusting NOPAT consistently), adding back unrecorded goodwill from pre‑2002 pooling acquisitions, eliminating non‑operating unconsolidated subsidiaries, and time‑weighting mid‑year acquisitions. Trainer provides concrete examples (Amazon’s hidden lease debt, Dynegy’s massive write‑downs, Apple and Microsoft’s excess cash, Tyson Foods’ acquisition timing) to show how each adjustment can swing ROIC dramatically. He also highlights New Constructs' extensive data set (70,000 filings since 1998 for over 3,000 companies), its machine‑learning‑assisted workflow that lets analysts focus on high‑impact items, and the firm’s role in helping regulators like the FASB identify accounting loopholes. The talk concludes by directing viewers to a detailed blog post and white paper for deeper dive into each adjustment.
Chapters
Our invested capital blog post, for the formula, the definition, and calculation, is the most popular article on our blog in terms of direct keyword search. More people come to us to find out how to calculate invested capital than just about anything else, and we think that's great. Invested capital specifically is the amount of capital put into the business over its life without regard to accounting name or financing form. How much capital has management accumulated over its life to generate its profits, or what we call NOPAT? It's the denominator in the return on invested capital calculation, and you can see my tutorial on return on invested capital. You can see my tutorial on NOPAT. And invested capital, again, is the denominator. NOPAT divided by invested capital. Now, it's important that invested capital represent all capital put into the business over its life, because, for example, if If you give a buddy some money and he says, hey, I got a business idea, and he says, I need $100 to make it happen, all right, you give him $100, he comes back and says, you know, I'm going to need another $100. You're like, okay, you're a good friend, I'll give you $100. He comes back and says, I need another $100. Overall, you give him $300. And then a couple years later, he starts paying you $50 a year and he's like, hey man, you're getting a really good investment because you're getting $50 on that $100 you gave me. And you just have to say, whoa, whoa, wait a second. I'm not getting $50 on $100, I'm getting $50 on $300. There's a big difference. So it's important to understand how much capital has gone into a business to truly and effectively measure the return on invested capital. I believe we do the best job in the world of measuring invested capital because of the work we do in the footnotes in the MD&A to go out and get all those scurrilous little details that you need to know the truth. And as I said in my tutorial on why data quality matters, you never know which data point is going to be the one that blows you up. Or the one that you overlook that can blow you up. That's why diligence across the entire filing is important. And we've built an unusual and unique proprietary technology to go through filings with scale. That is why FASB and other regulators rely on us to help them identify where companies are burying the bodies or where accounting loopholes are being exploited and to help them make sure that new rules don't include loopholes. We've been through 70,000 filings dating back to 1998. for over 3,000+ companies. We've seen everything there is to see, and we have machines and technology that helps us scale this expertise and allows us to know more about everything. And it's also what allows us to look at everything. Because we get the machines to do the easy stuff, my highly trained, highly intelligent analysts can go through and identify the things that most people don't have time or patience to look for. I'll be honest, even my friends who actually say they like to read 10-Ks, They got maybe 1 or 2 of them per year. Most people, and these are portfolio managers in major fund houses and hedge funds, will tell me, you got maybe 1 or 2 of these things in your lifetime. That's how boring and difficult they are. That's why you need a machine to go through it, and that's why I started New Constructs. So let's get to some specifics on where adjustments to invested capital matter. And I'm gonna give you all the specific adjustments that we make. There's 12 adjustments that we make to balance sheets to get to invested capital. I'm gonna go through every single one, and if you want more detail on any of these, go to my blog post, 30+ Adjustments to Get the Truth About Quality of Earnings and Valuation, where I'll give you examples that show that every one of these adjustments can be material. Not in every case, but every now and then. And that's why I say you never know which one of the data points is gonna be the one that blows you up. So one of the biggest adjustments we make, and one that FASB's been doing a lot of work on, Off-balance sheet debt due to operating leases. We've done more work on operating leases and know more about off-balance sheet debt than anybody in the world. And it's because we've been doing it since 1998, we've been collecting more data. It's a big adjustment, it can make a big difference for certain companies. For example, Amazon, over $4 billion in off-balance sheet debt. Most people don't realize is that Amazon is no longer the capital efficient or super high return on capital it once used to be. Why? company it once used to be because its balance sheet is growing. It's in a capital-intensive business now. Do you think the cloud is not capital-intensive? If you're going to be the server farm for everyone, it's very capital-intensive. Amazon's returns on capital are way down. Most of it's on the balance sheet. Most people don't even know it's on the balance sheet because they haven't— they don't see that there's $4 billion in off-balance sheet debt. Another big one is off-balance sheet reserves. That can mean anything from loan loss reserves to Debitory reserves, all kinds of reserves that people are creating. It could be deferred compensation reserves, all kinds of things that companies are putting off the balance sheet you don't know about, you need to add back because that is capital on which management should be earning return. And you wanna be apples to apples as well as accurate across all companies, so we bring it all on there. We convert all operating leases to capital leases, we bring all off-balance sheet reserves back on board as long as they're related to the operations of the business. We remove discontinued operations. We remove accumulated other comprehensive income. We add back asset write-downs. That's a huge one. In fact, asset write-downs can be a leading indicator for stocks blowing up or even fraud. In a recent meeting with the SEC, we pointed out that companies that have the most egregious write-downs are ones that are some of the best candidates and companies they should red flag for fraud investigations. A great example is Dynegy, ticker Dyn. Right before they got busted for fraud back in 2012, we'd shown that over the prior 3 years, they'd done— they had accumulated after-tax write-downs of almost $4 billion, $3.85 billion. And that's after tax, right? Their balance sheet was less than that. So a lot less than that. In fact, their net assets were about a third. Of what the actual write-downs were. So put another way, for every dollar of assets on the balance sheet, Dynegy in the prior 3 years had written down $3.50. That's what you call shareholder value destruction, right? Management goes out, they buy a tractor for $100, 3 years later after depreciation it's worth $80, they say, oh, it's only worth $70, shoot! That's called— that's shareholder value destruction. Take an asset that they used shareholder capital to buy and later say that that shareholder capital is worth less. than it was when they bought it, net of depreciation. That's bad management. We track that. We have the best database in the world for that because we've been tracking these kinds of things for over 15 years. We also remove deferred tax assets and liabilities where they are non-operating and irrelevant. We remove overfunded pension assets because that's non-operating assets to get to the truth. And I think it's important to point out, look, we're taking stuff out and we're putting stuff in. We're not just trying to blow people up and raise a red flag and be scared, do scare tactics to make people think, oh, you know, everybody's profits are bad. A lot of times there are companies we like because of the things that we take out of the balance sheet that is reported on the balance sheet makes the company actually look a lot more profitable than what people think. That's a big part of what we do too. We're here to find good stocks and bad stocks. We're here to do the homework that most people don't have time to do. Reviewing the financial statements. remove excess cash, that's a big one. Huge one, you know, for companies like Apple, right, which gets an attractive rating from us now. When you— they have so much cash on the balance sheet, and when you remove that, the return on invested capital is much, much higher net of the excess cash than it is the actual full balance sheet when you include that cash. And I don't think you should include that cash. They shouldn't be required to earn a return on the cash flows or the profits they've made in the past. It's important to point out that we remove excess cash. Excess cash is defined, and you'll see this in my blog post if you want to look it up, there's a white paper on this, is defined as the cash over and above what the company needs to keep on hand to run its business. And, you know, Microsoft has historically had huge amounts of excess cash. And, you know, you need to take that out of your invested capital calculation to measure the operational returns on capital. How much cash flow is Microsoft generating relative to the capital that's put in use to create cash flow? Naturally, of course, one of our adjustments on the NOPAT side is to remove any net income related to excess cash, so we're always consistent with the numerator and the denominator. That's a huge theme for our return on invested capital calculations. Whatever we do to the denominator, we have to do to the numerator. What's good for the goose is good for the gander. What's good for the numerator is good for the denominator. Same idea. Prior to 2002, we had to add back a bunch of unrecorded and accumulated goodwill. 'Cause unrecorded goodwill came from pooling acquisitions, which FASB fortunately made illegal as well, because companies used to love pooling acquisitions because they could basically go out and buy a company and not record the market value of the assets of that company on their balance sheet. They only recorded the book value. It's hard to believe. If you didn't live through it, you wouldn't believe that it's true, but trust me, these adjustments are huge in certain cases. And we— because we're going back to 1998, we're making that adjustment. And also because we're going back to 1998, We're giving people a better perspective on the 3,000 companies we cover of all the capital that's been put in the business over its life, and that's important to measuring returns on capital. We also remove non-operating unconsolidated subsidiaries. We're taking out, you know, the non-operating subsidiaries, things that aren't really relevant to the true operations of the business. If it's not contributing to NOPAT, it shouldn't be in the invested capital. Another really big adjustment we make is for mid-year acquisitions. Or any acquisition after the first of the year. The way the financial statements work is that companies in their annual report only record the income from an acquisition post the close. So if a company were to close an acquisition on December 1st, well, they'd only get one month of revenue and income from that acquisition, but on their balance sheet they would show the full amount of the acquisition. Greatly distorts returns. Okay. So we time weight that acquisition so that we only show 1 month's worth of the acquisition, so that it's consistent with 1 month's worth of the income and revenue that comes from it. Big adjustment, particularly big adjustment for Tyson Foods. They show a balance sheet of $24 billion, we show invested capital of just $12 billion, and most of that is related to the adjustment of the time weighting of the acquisition, or the capital related to the acquisition. Those are all the adjustments we make. Any questions, again, go to the blog, see more details.
