The concept of stewardship has always appealed to me. It conjures up an image of someone looking after something that doesn’t belong to them with the aim of leaving it in better condition than they found it. Put like that, it’s a good summary of a director’s fiduciary duties.
There are, of course, many ways of measuring stewardship and no one metric will satisfy everyone. Different stakeholders want different things and all metrics can be gamed. It is therefore tempting to simply ignore the issue of metrics and just move on.
I think this is a mistake because there is one overlooked metric that is remarkably effective for monitoring stewardship: return on capital employed (ROCE). Calculated properly, ROCE will give a very good indication over time of how well shareholders’ capital has been deployed.
The ‘calculated properly’ rider is crucial here. ROCE is a non-GAAP term, and the numerator and denominator are also non-GAAP. Current IFRS Accounting Standards do not make it easy to derive satisfactory inputs.
Ignoring impaired goodwill is like describing British weather without mentioning the rain
Defining ROCE
Let’s start with capital employed. I want this number to reflect all the capital that has been invested in the business: shareholders’ funds, net debt, and with all written-off goodwill added back. This last item is crucial. Goodwill may vanish from the balance sheet when it is impaired, but it is real money that was spent to improve the business.
Calculating capital employed without impaired goodwill is like describing British weather without mentioning the rain. It gives a fundamentally misleading picture, particularly for companies with poor acquisition records. In other words, for most companies.
I also want to add back all amortised intangible assets that were artificially created during the purchase price allocation process. These ‘assets’ are just disguised goodwill and should be treated as such. Personally, I don’t treat pension deficits as net debt for ROCE purposes; pension funding shortfalls are volatile and often bear no relation to the ultimate cash liability.
It’s an example of the accounting world not understanding what investors really want
It is worth mentioning that under current IFRS rules, it can be very difficult to add back all acquisition intangibles. I doubt that the standards were deliberately drafted with this in mind; it’s just another example of the accounting world not understanding what investors really want. I mentioned this to the chief accountant of a Big Four firm recently and his response was: ‘Oh, I had never thought of that.’
For the return numerator, I use operating profit; not, sadly, the definition of the incoming IFRS 18, Presentation and Disclosure in Financial Statements, because I want to exclude the amortisation of acquired intangibles. I also want to exclude the marking to market of derivatives, genuinely one-off restructuring and anything that is not a result of regular business operations. Inventory write-downs are included, as these are simply the early recognition of a forthcoming operating loss. I recognise deciding what to include and exclude will always involve some subjectivity.
Simple scorecard
This approach is not perfect. I knew a company that almost failed after paying out billions for asbestos liabilities. The cost of the payments came off shareholders’ equity. The company survived (just) and then went on to deliver fantastic ROCE because most of its capital had vanished.
ROCE gives a simple scorecard that can be used across multiple sectors
Perhaps the best thing about measuring ROCE in the way I have outlined is that it gives a simple scorecard that can be used across multiple sectors. Anything less than 10% means that the company has been poorly managed and probably has an awful acquisition track record; 10%–15% is common and merits an average score; 15%–20% is more respectable but nothing special; 20%–30% deserves a silver star.
The best-managed companies deliver 30%+ and in my experience are the least likely to wreck their record with an overpriced acquisition. Gold star for stewardship.
