8CHAPTER

Return on Invested Capital

• Joint analysis is where one measure is assessed relative to another

• Return on invested capital (ROI) is an important

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 CapitalImportance of Joint Analysis

Return on Invested Capital ROI Relation

• ROI relates income, or other performance measure, to a company’s level and source of financing

• ROI allows comparisons with alternative investment opportunities, and with same opportunity over time

• Riskier investments are expected to yield a higher ROI

• ROI impacts a company’s ability to succeed, attract financing, repay creditors,and reward owners

• ROI relates income, or other performance measure, to a company’s level and source of financing

• ROI allows comparisons with alternative investment opportunities, and with same opportunity over time

• Riskier investments are expected to yield a higher ROI

• ROI impacts a company’s ability to succeed, attract financing, repay creditors,and reward owners

Return on Invested CapitalApplication of ROI

(1) evaluating managerial effective-

ness

(2) assessing

profitability

(3) earnings

forecasting

(4) planning and

control

ROI is applicable to:

Return on Invested CapitalEvaluating 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

• 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 CapitalMeasuring 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

• 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 CapitalAssists in Forecasting Earnings

• ROI links past, current, and forecasted earnings with invested capital

• ROI adds discipline to forecasting

• ROI helps identify optimistic or pessimistic forecasts

• ROI aids in evaluating prior forecast performance

• ROI links past, current, and forecasted earnings with invested capital

• ROI adds discipline to forecasting

• ROI helps identify optimistic or pessimistic forecasts

• ROI aids in evaluating prior forecast performance

Return on Invested CapitalFor Planning and Control

ROI assists managers with:

• Planning• Budgeting• Coordinating activities• Evaluating opportunities• Control

ROI assists managers with:

• Planning• Budgeting• Coordinating activities• Evaluating opportunities• Control

Components of ROIDefinition

Return on invested capital is defined as:Return on invested capital is defined as:

capital Invested

Income

Components of ROIInvested Capital Defined

• No universal measureof invested capital exists

• Different measures of invested capital reflect different financiers’ perspectives

Components of ROIAlternative Measures of Invested Capital

Five Common Measures:• Total Assets• Long-Term Debt Plus Equity• Common Equity• Market Value of Invested Capital (debt and equity)

• Investor Invested Capital

Components of ROITotal 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

• 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 ROITotal Assets

Some adjust this invested capital base for:

1. Unproductive Assets (subtracted)

2. Intangible Assets (subtracted)

3. Accumulated Depreciation (not subtracted)

Some adjust this invested capital base for:

1. Unproductive Assets (subtracted)

2. Intangible Assets (subtracted)

3. Accumulated Depreciation (not subtracted)

Components of ROITotal Assets

Unproductive Asset Adjustment• Assumes management not responsible for earning a return on capital not in operations• Excludes inactive plants, facilities under

construction, surplus plants, surplus inventories, surplus cash

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

Unproductive Asset Adjustment• Assumes management not responsible for earning a return on capital not in operations• Excludes inactive plants, facilities under

construction, surplus plants, surplus inventories, surplus cash

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

Components of ROITotal Assets

Intangible Asset Adjustment

Excludes intangible assets from invested capital assuming skepticism about their values

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

Intangible Asset Adjustment

Excludes intangible assets from invested capital assuming skepticism about their values

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

Components of ROITotal 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

Adjustment is not valid as: 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

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

Adjustment is not valid as: 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 ROILong-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 “Return on long-term capitalization”

• Excludes current liability financing

• Perspective is that of the two main suppliers of long-term financing —long-term creditors and equity shareholders

• Referred to as “Return on long-term capitalization”

• Excludes current liability financing

Components of ROI

Common Equity Capital

• Perspective is that of common equity holders

• Captures the effect of leverage (debt) capital on equity holder return (financial leverage)

• Excludes all debt financing and preferred equity

• Perspective is that of common equity holders

• Captures the effect of leverage (debt) capital on equity holder return (financial leverage)

• 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)

• 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

• 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 ROIComputing 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 ROIIncome 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 ROIAdjustments to Invested Capital and Income Numbers

Many accounting numbers require analytical adjustment—see 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

Many accounting numbers require analytical adjustment—see 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 ROIReturn on Assets -- ROA

2 assets) total Ending assets total (Beginningincome interest Minority rate)Tax (1 expense Interest income Net

Components of ROIReturn on Long-Term Debt plus Equity

equity) Averagedebt term-long (Average

income ininterest Minorityrate) Tax(1 expenseInterest incomeNet

[Also called return on long-term capitalization]

Components of ROI

Return on Common Equity -- ROCE

Net income - Preferred dividendsTotal common shareholders’ equity

[When ROCE is higher than ROA, it often reflects favorable impacts of leverage]

Net income - Preferred dividendsTotal common shareholders’ equity

[When ROCE is higher than ROA, it often reflects favorable impacts of leverage]

Analyzing Return on Assets--ROA

Disaggregating ROA

Assets

Sales

Sales

Income

Assets

Income

Profit margin: measures profitability relative to sale (RETURN ON SALES)

Asset turnover (utilization): measures effectiveness in generating sales from assets

Return on assets = Profit margin x Asset turnover

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

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Analyzing Return on Assets--ROARelation Between Profit Margin and Asset Turnover

Profit Margin, Asset Turnonver, and Return on Assets for Selected Industries

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1

1.5

2

2.5

3

3.5

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Profit margins %

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ROA = 5%Food Stores

AgricultureAmusements

Health Services

MetalsPetroleum

Air TransportationPaper

Building Materials

ConstructionChemicals

Fisheries

Tobacco

Oil & Gas

Hotels

Museums

Real Estate

Auto Dealers

Wholesale TradeBuilders

Wholesale-Nondurables

Transportation Service

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

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 Assets--ROADisaggregating Asset turnover

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Analyzing Return on Common Equity--ROCE

Role in Equity Valuation

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

This can be restated in terms of future ROCE:

Analyzing Return on Common Equity--ROCE

Disaggregating ROCE

• 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.

ROCE = Adjusted profit margin × Asset turnover × Leverage

equity common Average

assetsAverage

assets Average

Sales Sales

dividends Preferredincome Net

equity common Average

dividends Preferredincome Net

Adjusted profit margin = Pre-tax adjusted profit margin x Retention rate

Adjusted profit margin = Pre-tax adjusted profit margin x Retention rate

Analyzing Return on Common Equity--ROCE

Further Disaggregation of Adjusted Profit Margin

Pre-tax adjusted profit margin: measure of operating effectiveness

Retention rate: measure of tax-management effectiveness

dividends Preferredearningstax -Pre dividends Preferred

income Net

Sales

dividends Preferred earningstax -Pre

Sales

dividends Preferredincome Net

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

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

Further Disaggregation of ROCE

Analyzing Return on Common Equity--ROCE

Assessing Equity Growth

equity rs’stockholde common Averagepayout Dividend dividends Preferred income Net = rate growth Equity

• Assumes earnings retention and a

constant dividend payout

• Assesses common equity growth rate through earnings retention

• 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

Assumes internal growthdepends on both earnings retention and return earned on the earnings retained

Assumes internal growthdepends on both earnings retention and return earned on the earnings retained

rate) Payout(1 ROCE = rate growth equity eSustainabl

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

• 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

Analyzing Leverage on Common Equity ($ thousands)

Financing Source Average Funds Earnings on Funds Payment to Accruing to (DetractingSupplied Supplied at 5.677% Financiers from) Return on Common

EquityCurrent liabilities $ 176,677 $ 10,030 $ 412(a) $ 9,618

Long-term debt 353,985 20,096 11,817(b) 8,279

Deferred taxes 93,962 5,334 none 5,334

Preferred stock 41,538 2,358 2,908(c) (550)

Earnings in excess of return to financiers $ 22,681

Add: Common equity 686,640 38,980 — 38,980

Totals $ 1,352,802 $ 76,798 $ 15,137

Total return to shareholders $ 61,661

Return on assets 5.677%

Leverage advantage accruing to common equity 3.303

Return on common equity 8.980%

Analyzing Return on Common Equity--ROCE

Return on Shareholders’ Investment--ROSI

(cost) price Share

reinvested earnings of ueMarket val Dividends

ROSI