Haynes Publishing – Return on capital used

Haynes (LSE:HYNS) uses a lot of shareholders money and we need to assess whether that money generates a good rate of return.  There are different ways of measuring the money tied up in the business, ranging from “net assets” to “capital employed” defined as average total assets less current liabilities.  Haynes’ directors regard the latter to be the most suitable measure.  They divide “adjusted operating profit” by total assets less current liabilities. This is one of their key performance indicators. The results for the last five years are not pretty – their unsightliness is something I prompted the directors at the AGM last week to acknowledge.

Haynes’ calculation of their Return on Average Capital Employed

In 2018 adjusted operating profit was £3.5m, total assets (averaged over the year) were £59.6m, and current liabilities (averaged) were £12.2m, therefore ROACE = £3.5m/£47.4m = 7.4%.

A plethora of returns

Any measure of return on capital can be criticised.  In the case of the metric used by Haynes you might object to ignoring all non-current liabilities.  If they were deducted then the capital number falls to £23m and the return looks respectable at £3.5m/£23m = 15.2%.

(Note that £18m of non-current liabilities is pension fund deficit – should this be deducted? Doesn’t the deficit move all over the place from one year to another, so if it was deducted we get a return on capital figure that jumps around dependent on actuarial assumptions? Is that fair? The deficit may simply disappear when interest rates rise.)

Then you might object to the use of an “adjusted” number in the numerator – should we use the warts’n all statutory reported number instead? I suppose much depends on which number most represents the underlying performance.

And shouldn’t you use profits after deducting taxation and after allowing for finance income/costs, i.e. after-tax profit rather than operating profit?  After all, shareholders are interested in what is attributable to them after the taxman has taken his cut.

So, working out a universally acceptable measure of return on capital is far from easy – impossible even, in most companies. But we have to do something to gain perspective on the managers’ use of money entrusted to them; and we have to have some evidence from the past when we are trying to think through likely future returns.

A year ago I agonised over this subject and wrote some newsletters setting out the complexities (see those posted 8^th to 14^th November 2017).  Out of that work I developed my own method.

I follow Warren Buffett in being interested in profit after tax has been deducted. I also add back to profit the amount deducted for amortisation of accounting goodwill. As Buffett says, “One reality is that the amortization charges that have been deducted as costs in the earnings statement each year since acquisition….were not true economic costs”.

And if you want to evaluate managers’ efficiency regarding an investment then the shareholders’ money they used to pay for an acquisition, including all the accounting goodwill already deducted should be added back to the capital figure.  Buffett commented on this,

“In evaluating the wisdom of business acquisitions, amortization charges should be ignored….They should be deducted neither from earnings nor from the cost of the business. This means forever viewing purchased Goodwill at its full cost, before any amortization.”

Return on net tangible asset value, RONTA

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