Advanced Issues  237 Since Costco does not provide pension benefits to employees, we do not adjust the company’s historical statements. Chapter 23 provides details on how to adjust NOPAT for pensions and how to factor under- or overfunded pensions into a company’s value. Capitalized Research and Development In line with the conservative principles of accounting, accountants expense R&D, advertising, and certain other costs in their entirety in the period when they are incurred, even when economic benefits resulting from such expenses continue beyond the current reporting period.16 This practice can dramatically understate invested capital and overstate return on capital for some compa- nies. Therefore, you should consider whether it would be effective to capi- talize and amortize R&D and other quasi investments in a manner like that used for capital expenditures. Equity should be adjusted correspondingly to balance the invested-capital equation. If you decide to capitalize R&D, do not deduct the reported R&D expense from revenue to calculate operating profit. Instead, deduct the amortization associated with past R&D investments, using a reasonable amortization sched- ule. Since amortization is based on past investments (versus expense, which is based on current outlays), this approach will prevent reductions in R&D from driving short-term improvements in ROIC. Whether or not you capitalize certain expenses will not affect computed value; it will affect only the timing of ROIC and economic profit. Chapter 24 analyzes the complete valuation process for R&D-intensive companies, in- cluding adjustments to free cash flow and value. Other Advanced Adjustments Some companies may have industry-specific items that require adjustment. These adjustments arise from an uncommon line item on the income state- ment or balance sheet and, given their rarity, require thoughtful judgment based on the economic principles of this book. Consider an example from FedEx. In 2013, the company sold aircraft to another company and leased the aircraft back. This transaction is commonly known as a sale-leaseback. If a gain arises from the sale, the company cannot recognize the gain as income, but instead must lower the annual rental ex- pense over the life of the contract. Since cash increases but retained earnings do not rise, a liability for deferred gains is recognized. 16 One exception to this conservatism is the development of software. Although software is an intan- gible asset, both GAAP and IFRS accounting allow for certain software investments to be capitalized and amortized over the life of the asset. 238  Reorganizing the Financial Statements Should the liability for deferred gains be treated as operating and deducted from operating assets to determine invested capital? Or perhaps classified as a debt or equity equivalent? From a valuation perspective, it doesn’t matter how to classify the item, as long as it is treated consistently. It will, however, have an impact on our perceptions about return on invested capital and ulti- mately value creation. Accounting rules prevent the one-year spike in income caused by a financial transaction, but we believe the downward distortion in future rental expense is worse, since this lower rental expense is noncash and could distort the perceived cost of new leases. Therefore, undo the transaction entirely and recognize the account as an equity equivalent. Not every advanced issue will lead to material differences in ROIC, growth, and free cash flow. Before collecting extra data and estimating required un- knowns, decide whether the adjustment will further your understanding of a company and its industry. An unnecessarily complex model can sometimes obscure the underlying economics that would be obvious in a simple model. Remember, the goal of financial analysis is to provide a strong context for good financial decision making and robust forecasting, not to create an overly engineered model that deftly handles unimportant adjustments. 239 12 Analyzing Performance Understanding a company’s past is essential to forecasting its future, so a thorough analysis of historical performance is a critical component of valu- ation. Always begin with the core elements of value creation: return on in- vested capital (ROIC) and revenue growth. Examine trends in the company’s long-run performance and its performance relative to that of its peers, so you can base your forecasts of future cash flows on reasonable assumptions about the company’s key value drivers. Start by analyzing ROIC, both with and without goodwill. ROIC with goodwill measures the company’s ability to create value over and above pre- miums paid for acquisitions. ROIC without goodwill is a better measure of the company’s underlying operating performance compared with that of its peers. Then drill down into the components of ROIC to build an integrated view of the company’s operating performance and understand which aspects of the business are responsible for its overall performance. Next, examine what drives revenue growth. Does revenue growth stem, for instance, more from organic growth or from currency effects, which are largely beyond man- agement control and probably not sustainable? Finally, assess the company’s financial health to determine whether it has the financial resources to conduct business and make investments for growth. Analyzing Returns on Invested Capital Chapter 11 reorganized the income statement into net operating profit after taxes (NOPAT) and the balance sheet into invested capital. ROIC measures the ratio of NOPAT to invested capital: ROIC NOPAT Invested Capital =