Return on Invested Capital

8
CHAPTER

Return on Invested Capital

Importance of Joint Analysis Joint analysis is where one measure is assessed relative to another Return on invested capital (ROI) is an important joint analysis

Return on Invested Capital

ROI Relation
ROI relates income, or other performance measure, to a companys level and source of financing ROI allows comparisons with alternative investment opportunities

Riskier investments are expected to yield a higher ROI

ROI impacts a companys ability to succeed, attract financing, repay creditors,and reward owners

Return on Invested Capital

Application of ROI
ROI is applicable to: (1) evaluating managerial effectiveness (3) earnings forecasting (2) assessing profitability

(4) planning and control

Return on Invested Capital

Evaluating Managerial Effectiveness

Management is responsible for all company activities ROI is a measure of managerial effectiveness in business activities ROI depends on the skill, resourcefulness, ingenuity, and motivation of management

Return on Invested Capital

Measuring Profitability

ROI is an indicator of company profitability ROI relates key summary measures: profits with financing ROI conveys return on invested capital from different financing perspectives

Return on Invested Capital

Assists in Forecasting Earnings
ROI links past, current, and forecasted earnings with
invested capital

ROI adds discipline

to forecasting

ROI helps identify

optimisticor pessimistic forecasts

ROI aids in evaluating prior forecast performance

Return on Invested Capital

For Planning and Control

ROI assists managers with: Planning Budgeting Coordinating activities Evaluating opportunities Control

Components of ROI
Definition

Return on invested capital is defined as:

Income Investedcapital

Components of ROI
Invested Capital Defined No universal measure of invested capital exists Different measures of invested capital reflect different financiers perspectives

Components of ROI
Alternative Measures of Invested Capital

Five Common Measures: Total Assets Long-Term Debt Plus Equity Equity Market Value of Invested Capital Investor Invested Capital

Components of ROI
Total Assets
Perspective is that of its total financing base Called return on assets (ROA) ROA: measures operating efficiency/ performance reflects return from all financing does not distinguish return by financing sources

Components of ROI
Total Assets

Some adjust this invested capital base for:

1. Unproductive Assets
2. Intangible Assets 3. Accumulated Depreciation

Components of ROI
Total Assets
Unproductive Asset Adjustment Assumes management not responsible for earning a return on capital not in operations Excludes idle plant, facilities under construction, surplus plant, surplus inventories, surplus cash, and deferred charges from invested capital

Adjustment is not valid as it fails to: recognize that management has discretion over all investment assess overall management effectiveness

Components of ROI
Total Assets
Intangible Asset Adjustment
Assumes skepticism of intangible asset values Excludes intangible assets from invested capital

Adjustment is not valid as: Lack of information or increased uncertainty does not justify exclusion

Components of ROI
Total Assets
Accumulated Depreciation Adjustment Assumes plant assets maintained in prime condition Assumes inappropriate to assess return relative to net assets Concern with a decreasing invested capital base Includes an addback for accumulated depreciation on depreciable assets Adjustment is not valid as: ROA analysis focuses on the performance of the entire company It is inconsistent with computation of income net of depreciation expense Acquisitions of new depreciable assets offset a declining capital base It fails to recognize increased maintenance costs as assets age

Components of ROI
Long-Term Debt Plus Equity Capital Perspective is that of the two main suppliers of long-term financing long-term creditors and equity shareholders Referred to as long-term capitalization Excludes current liability financing

Components of ROI
Equity Capital
Perspective is that of equity holders

Captures the effect of leverage (debt) capital on equity holder return Excludes all debt financing and preferred equity

Components of ROI
Market Value of Invested Capital

Assumes certain assets not recognized in financial statements Uses the market value of invested capital (debt and equity)

Components of ROI
Investor Invested Capital

Perspective is that of the individual investor Focus is on individual shareholder, not the company Uses the purchase price of securities as invested capital

Components of ROI
Computing Invested Capital

Usually computed using average capital available for the period Typically add beginning and ending invested capital amounts and divide by 2 More accurate computation is to average interim amounts quarterly or monthly

Components of ROI
Income Defined
Definition of income (return) depends on definition of invested
capital

Measures of income in computing return on invested capital must reflect all applicable expenses from the perspective of the capital contributors Income taxes are valid deductions in computing income for return on invested capital Examples: Return on total assets capital uses income before interest expense and dividends Return on long-term debt plus equity capital uses income before interest expense and dividends Return on common equity capital uses net income after deductions for interest and preferred dividends

Components of ROI
Adjustments to Invested Capital and Income Numbers

Many accounting numbers require analytical adjustmentsee prior chapters Some numbers not reported in financial statements need to be included Such adjustments are necessary for effective analysis of return on invested capital

Components of ROI
Return on Assets -- ROA

Net income Interestexpense(1 Tax rate) Minorityinterestin income (Beginning total assets Ending total assets) 2

Components of ROI
Return on Long-Term Debt plus Equity

Net income Interest expense (1Tax rate)Minority interest in income (Average long-term debt Average equity)

[Also called return on long-term capitalization]

Components of ROI
Return on Common Equity -- ROCE
Net income - Preferred dividends Total common shareholders equity [When ROCE is higher than ROA, it often reflects favorable impacts of leverage] ROCE is approximated by

Basic earnings per share Book value per share

Analyzing Return on Assets--ROA

Disaggregating ROA

Return on assets = Profit margin x Asset turnover

Income Income Sales Assets Sales Assets

Profit margin: measures profitability relative to sale Asset turnover (utilization): measures effectiveness in generating sales from assets

Analyzing Return on Assets--ROA

Relation Between Profit Margin and Asset Turnover
Profit margin and asset turnover are interdependent

Relation between Profit Margin, Asset Turnover, and Return on Assets

3.75 3.5 3.25 3 2.75 2.5 2.25 2 1.75 1.5 1.25 1 0.75 C 0.5 0.25 0

Asset turnover

A D E B H I J P F G Y K L M N X O

-2

-1

10

11

12

13

14

15

16

Profit margins %

Analyzing Return on Assets--ROA

Relation Between Profit Margin and Asset Turnover
6 5.5 5 4.5

Profit Margin, Asset Turnonver, and Return on Assets for Selected Industries
ROA = 5% Food Stores Transportation Service Wholesale-Nondurables Auto Dealers Builders Wholesale Trade Building Materials Paper Construction Air Transportation Chemicals Tobacco Petroleum Metals Fisheries Oil & Gas Health Services Hotels Amusements Agriculture Museums
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5 8

Asset turnover

4 3.5 3 2.5 2 1.5 1 0.5 0

Real Estate

Profit margins %

Analyzing Return on Assets--ROA

Asset Turnover Analysis

Asset turnover measures the intensity with which companies utilize assets Relevant measure is the amount of sales generated

Analyzing Return on Assets--ROA

Disaggregating Asset turnover
Sales to Cash: Reflects trade-off between liquidity and accumulation of low-return funds Sales to Receivables: Reflects trade-off between increased sales and accumulation of funds in receivables Sales to Inventories: Reflects trade-off between funds accumulated in inventory and the potential loss of current and future sales Sales to Fixed Assets: Reflects trade-off between fixed asset investments having high break-even points and investments in more efficient, productive assets with high sales potential

Sales to Other Assets: Reflects trade-off between assets held for current and future sales and accumulation of funds in higher risk assets
Sales to Current Liabilities: Reflects a relation between sales and current trade liabilities

Analyzing Return on Common Equity--ROCE

Role in Equity Valuation

V BV t t

NI (k BV ) NI (k BV ) NI (k BV ) t t 2 t1 t1 . . . tn tn1 . . . (1 k) (1 k)n (1 k)2

This can be restated in terms of future ROCE:

V BV t t

(ROCE k)BV (ROCE k)BV (ROCE k)BV t tn t1 t 2 t1 . . . tn1 . . . n (1 k) 2 (1 k) (1 k)

where ROCE is equal to net income available to common shareholders (after prefered diviends) divided by the beginning-of-period common equity

Analyzing Return on Common Equity--ROCE

Disaggregating ROCE
ROCE = Adjusted profit margin Asset turnover Leverage
Average Net income Net income Preferreddividends Preferreddividends assets Sales Sales Average Average Average assets common equity common equity

Adjusted profit margin: portion of each sales dollar remaining for common shareholders after providing for all costs and claims (including preferred dividends) Asset turnover (utilization): measures effectiveness in generating sales from assets Leverage*: measures the proportion of assets financed by common shareholders
*Also called financial leverage and common leverage.

Analyzing Return on Common Equity--ROCE

Further Disaggregation of Adjusted Profit Margin Adjusted profit margin = Pre-tax adjusted profit margin x Retention rate
Pre-tax earnings Net income Net income Preferreddividends Preferreddividends Preferreddividends Sales Sales Pre-tax earnings Preferreddividends

Pre-tax adjusted profit margin: measure of operating

effectiveness
Retention rate: measure of tax-management effectiveness

Analyzing Return on Common Equity--ROCE

Further Disaggregation of ROCE

ROCE = [(EBIT profit margin Asset turnover) Interest burden] Leverage Retention rate
EBIT is earnings (income) before interest and taxes (and before any preferred dividends) EBIT profit margin is EBIT divided by sales Interest burden is interest expense divided by average assets This disaggregation highlights effects of both interest and taxes on ROCE

Analyzing Return on Common Equity--ROCE

Assessing Equity Growth
Equity growth rate = Net income Preferreddividends Dividendpayout Averagecommon stockholders equity

Assumes earnings retention and a constant dividend payout Assesses common equity growth rate through earnings retention

Analyzing Return on Common Equity--ROCE

Assessing Equity Growth
Sustainable equity growthrate = ROCE (1Payout rate)

Assumes internal growth depends on both earnings retention and return earned on the earnings retained

Analyzing Return on Common Equity--ROA

Leverage and ROCE
Leverage refers to the extent of invested capital from other than common shareholders If suppliers of capital (other than common shareholders) receive less than ROA, then common shareholders benefit; the reverse occurs when suppliers of capital receive more than ROA The larger the difference in returns between common equity and other capital suppliers, the more successful (or unsuccessful) is the trading on the equity

Analyzing Return on Common Equity--ROCE

Analyzing Leverage on Common Equity
Financing Source Analyzing Leverage on Common Equity ($ thousands) Average Funds Earnings on Funds Payment to Accruing to (Detracting Supplied Supplied at 5.677% Financiers from) Return on Common Equity (a) $ 176,677 $ 10,030 $ 412 $ 9,618 353,985 93,962 41,538 686,640 $ 1,352,802 20,096 5,334 2,358 38,980 $ 76,798 11,817(b) none 2,908 $ 15,137 $ 61,661 5.677% 3.303 8.980%
(c)

Current liabilities Long-term debt Deferred taxes Preferred stock Add: Common equity Totals

8,279 5,334 (550) $ 22,681 38,980

Earnings in excess of return to financiers

Total return to shareholders Return on assets Leverage advantage accruing to common equity Return on common equity

Analyzing Return on Common Equity--ROCE

Return on Shareholders Investment--ROSI

Dividends Market val ue of earnings reinvested ROSI Share price (cost)