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• Companies with lumpy capital expenditure patterns.
While ROIC is the best single return measure, like other historical cost accounting measures, it can be distorted by inflation. To remedy this Exhibit 9.12 Hershey Foods—Comparison of Adjusted and Unadjusted ROIC
distortion it is sometimes suggested to adjust net property, plant, and equipment using either of three approaches: replacement cost, market values, or inflation-adjusted costs. Let's explore each in turn.
The replacement cost approach values the plants at the cost to replace them today. We disagree with the replacement cost approach for the simple reason that assets do not have to be and may never be replaced. It may be economically justifiable to continue to use an old asset even though the cost of replacing it with new equipment may outweigh the higher profits that the new asset will eventually generate. Furthermore, a company with a plant built several years before its competitors (assuming the same productivity potential) at a lower cost than its competitors' plants has a real competitive advantage that should be reflected in a higher ROIC. This advantage is similar to a company that has lower labor costs because its workers are nonunionized or a company located in a low tax jurisdiction. These advantages must be reflected in a company's returns.
Using the market values of assets is appropriate when the realizable market value of the assets substantially exceeds the historical cost book value. You are only likely to find tangible assets with such high values in the case of assets that have general uses beyond the company's current use of the assets. Real estate and airplanes are good examples where the realizable market values of the assets might exceed the book values. For most assets, such as equipment, computers, and fixtures, the market values for used assets are generally very low. For most companies, the proportion of assets with market values significantly higher than book values is low, so calculating ROIC based on book values does not introduce significant distortions.
If market values are used, NOPLAT must be adjusted to reflect the annual appreciation of the value of the assets. It would be inconsistent to write up the assets without reflecting the appreciation in profits. This is a common error that we see when analysts argue for using market values. They ignore the economic profit associated with the write-up.
It could be argued that the reason for writing up the assets and for not including the appreciation in profits is to get a sense of whether a company's assets would be better used some other way. Consider a retailer that owns valuable real estate. The retailer might earn less than its cost of capital if the market value of the real estate were used instead of its book value. While this is true, remember we are trying to analyze the company's actual performance, not whether it is making the best use of its assets. Companies should do both, measure actual performance and determine whether or not they are making the best use of their assets.
Finally, adjusting assets for inflation is complex. For every year, you must decompose the fixed assets into layers based on when they were purchased. Then each layer is revalued using an appropriate price index. Depreciation must be revalued using a price index. ROIC can then be
estimated by dividing the adjusted NOPLAT by the adjusted invested capital. This ROIC is a real ROIC and must be compared to a real cost of capital (excluding inflation). While this approach is sensible in theory it is complex to apply and difficult to work with. It is particularly useful, however, in high inflation environments. See Chapter 19, Valuation in Emerging Markets, for an example of how to apply this approach.
To wrap up this and each of the next four chapters, we present a case study: Heineken N.V.3 This case will illustrate the concepts from each of the chapters and provide a comprehensive integration of all the pieces of a valuation.
The Netherlands-based Heineken is one of the largest beer companies in the world, and enjoys the second-largest market share, behind Anheuser-Busch. Its main brands are the popular Heineken and Amstel beers. In 1998, the last year used in our valuation, Heineken had revenues of NLG 13.8 billion4 and had over 33,500 employees worldwide. It is also the most international brewer: only 9 percent of its revenues comes from the Netherlands. Forty-one percent of revenues originates in the rest of Europe, 6 percent from North America, and the remaining 44 percent from Latin America, Asia, and Africa. In addition, only 25 percent of its sales comes from its flagship brands; the rest is from Heineken-owned regional brands.
In this chapter of our case study, we analyze the historical performance of Heineken and develop an understanding of the beer market and how Heineken has performed relative to the market.
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