240  Analyzing Performance Companies that report ROIC in their annual reports may compute it using starting invested capital, ending capital, or the average of the two. Since profit is measured over an entire year, whereas capital is measured only at one point in time, we recommend that you average starting and ending invested capital. If the business is highly seasonal, such that capital is changing substantially at the company’s fiscal close, consider using quarterly averages. ROIC is a better analytical tool than return on equity (ROE) or return on as- sets (ROA) for understanding the company’s performance because it focuses solely on a company’s operations. ROE mixes operating performance with capital structure, making peer-group analysis and trend analysis less insight- ful. ROA—even when calculated on a pre-interest basis—is an inadequate measure of performance because it includes nonoperating assets and ignores the benefits of accounts payable and other operating liabilities that together reduce the amount of capital required from investors. As an example of using ROIC to analyze performance, Exhibit 12.1 plots ROIC for Costco and the median of its peers from 2015 to 2019, based on the NOPAT and invested-capital calculations presented in Chapter 11.1 Costco has consistently earned higher returns on invested capital than its peers, and 1 Costco’s fiscal year ends on the Sunday closest to August 31, so its 2019 fiscal year ended September 1, 2019. Its peers end their fiscal years in December or January, and their 2019 results were not available at the time of this writing. EXHIBIT 12.1  Costco versus Peer Group: Return on Invested Capital % 2015 2016 2018 2017 2019 Costco Peer group median1 0 5 10 15 25 20 1 ROIC measured on average capital without goodwill and acquired intangibles. 2 For peers, 2019 results were not available at the time of this writing. Costco’s fiscal year ended September 1, 2019, versus December 2019 to January 2020 for peers. Analyzing Returns on Invested Capital  241 showed significant increases in 2018 and 2019. As we will show later, Costco’s higher ROIC can be traced to its lower operating profit margin offset by strong capital productivity. Analyzing ROIC with and without Goodwill and Acquired Intangibles Goodwill and acquired intangibles are intangible assets purchased in an ac- quisition. ROIC should be computed both with and without goodwill and acquired intangibles. In our analysis, we treat goodwill identically to acquired intangibles.2 Therefore, we will often shorten the expression goodwill and ac- quired intangibles to simply goodwill. The reason to compute ROIC with and without goodwill is that each ratio analyzes different things. ROIC with goodwill measures whether the com- pany has earned adequate returns for shareholders, factoring in the price paid for acquisitions. ROIC excluding goodwill measures the underlying operating performance of a company. It tells you whether the underlying economics generate ROIC above the cost of capital. It can be used to compare a com- pany’s performance against that of peers and to analyze trends. It is not af- fected by the price premiums paid for acquisitions. ROIC without goodwill is also more relevant for projecting future cash flows and setting strategy. A company does not need to spend more on acquisitions to grow organically, so ROIC without goodwill is a more relevant baseline for forecasting cash flows. Finally, companies that have a high ROIC without goodwill will likely create more value from growth, while companies that have low ROIC without good- will will likely create more value by improving ROIC. Costco doesn’t have any goodwill, having grown entirely organically, but for companies that make significant acquisitions, the difference between ROIC with and without goodwill can be large. Exhibit 12.2 presents ROIC with and without goodwill for the U.S. luxury-goods maker Tapestry, formerly known as Coach. In 2017, the company purchased Kate Spade, a luxury fashion de- sign house, for $2.4 billion in cash. Since the two companies had quite similar returns on capital, Tapestry’s ROIC without goodwill remained fairly con- stant before and after the acquisition. In contrast, ROIC with goodwill after the acquisition fell from 24 percent to 12 percent in 2017. Does the decline in ROIC when measured with goodwill imply that the acquisition destroyed value? Not necessarily: cost savings and cross-selling opportunities take time to realize, and Tapestry’s access to new customers, especially millennials, may accelerate growth in its own product lines. 2 To be classified as an acquired intangible, the asset must be separable and identifiable, as in the case of patents. Goodwill describes assets that are not separable or identifiable. Acquired intangibles are amortized over the life of the asset, whereas goodwill is impaired if value falls below book value. Since we analyze the two accounts in the same manner, we do not make a distinction.