Return on Capital (ROC), Return on Invested

Capital (ROIC) and Return on Equity (ROE)

Measurement and Implications
Introduction

 Shift in corporate finance and valuation in recent years

• “Excess returns” –core to determining business value

 Measurement of excess returns – difficult

• Estimation of returns on investments
• How returns -expected to evolve over time
18-Jul-10 Merger, Acquisition & Corporate Valuation 3

ACCOUNTING RETURNS
Investment Returns
Assets Liabilities

Assets in Debt
place

Growth Assets Equity

Financial Balance Sheet

Investment Returns
 Two basic questions to be answered in corporate
finance &valuation

• How good are the firm’s existing investments? or do they

generate returns that exceed the cost of funding them?
o Analysis of past data
o Focus on the capital invested in assets in place & cash flows generated
o Compute ROIC & compare to cost of capital

• What do we expect the excess returns to look like on future

investments?
o Adjust past returns for changes
o Compute ROE or ROC & compare to cost of capital
Investment Returns
 Focus on measuring returns on past and future
investments
• Firm with higher ROI than costs of capital -Excess returns
• Firm – expects to continue generating positive excess returns on new
investments in future
• Greater value as growth increases

 Link between excess returns and value

• Explicit link in excess return models
o Value of a firm = sum of values of capital invested in existing assets in
firm & PV of future excess returns on existing assets and future
investments
• Implicit in conventional DCF models
Investment Returns
• Valuing a Business
• Estimate ROE & ROIC in existing assets –evaluate quality of
investments made
• Use returns - forecast returns on future investments
• Over estimation of returns earned on existing investments
o Misjudge quality of firm management
o Firm –> over-valued

• Key number in a valuation -Return earned on capital & not

cost of capital assigned to firm
Measuring Investment Returns
 Accounting Returns

1. Return on Invested Capital (ROIC)

ROIC = Operating Income t * (1-Tax Rate)

Book Value of invested Capital t-1

4 key components:
• Use of Operating Income rather than Net Income
• Tax adjustment
• Use of Book Values
• Timing Difference
After-tax Operating Income
 ROIC -measures return on all capital( debt+ equity) invested in
assets

 Need - to consider earnings to equity investors ( net income) &

earnings to lenders in form of interest payments

 So, operating income-

• As a pre-debt measure of earnings-used
• Adjusted for taxes- gives after-tax return on capital

 Estimation of After-Tax Operating Income-

• After-tax Operating Income = EBIT (1 – tax rate)
• After-tax operating income = Net Income + Interest Expenses (1- tax
rate) – Non-operating income (1 – tax rate)
Invested Capital
 Accounting return computation - reverts back to book
value to compute return on capital invested in
existing assets
 Assumption : Book values of debt & equity effectively
measure capital investment
 Market value of equity : Two problems
• Includes expected value of growth assets
o Cannot generate operating income today
o Hence, return on capital computed using market values of
debt & equity for a growth firm - biased downwards
o Not because firm - taken poor investments but because its
market value incorporates expectations for the future
Invested Capital
 Second Problem in taking market value of equity
• Market value marks up value of existing assets to reflect their
earning power
• Even with no growth assets, use of market value of existing
investments - will generate unsurprising result that return on
capital is equal to the cost of capital
• Net out cash to be consistent with use of operating
income as measure of earnings
• Interest income from cash - not part of operating income
• Invested Capital =( Fixed Assets + Current Assets –
Current Liabilities – Cash) or
= (Fixed Assets + Non-cash Working Capital)
Invested Capital
 Alternative: Use Book Value of Assets in place of Book value of
Debt & Equity
 Both approaches - equivalent results with two exceptions

• When firm has minority holdings in other companies that are classified
as assets on a balance sheet
o Such assets - not viewed as operating assets – so, excluded from
invested capital computation when we use the asset-based approach
o But, implicitly included when capital computation used

• When firm has long-term liabilities not categorized as debt –Like

unfunded pension or health care obligations
o Excluded from the invested capital computation when we use the capital
approach since only equity & interest bearing debt considered but
included in computation when asset approach used
Timing Differences
 Use of capital invested at start of period in computing
return on invested capital

 Rationale :
• Investments during course of 1 year - generally not start
generating earnings during year
• Divide operating income for the year by the capital invested at the
beginning of year

 Some analysts prefer to use average of capital invested

during the year
• Obtained by averaging capital invested at beginning & end of year
Return On Equity
 Return on equity
• Focuses on equity component of investment
• Relates earnings left over for equity investors after debt service costs have
been factored in to equity invested in asset
 Accounting definition of return on equity :
 Return on Equity (ROE) = Net Income (t)
Book Value of Equity (t -1)
 Key difference between ROE & ROIC:
• Cash - not netted out
• Interest income from cash - part of net income
• Book value of equity incorporates cash holdings firm

 ROE for a firm - a composite return on all of its assets –

cash and operating
Return On Equity
 Non - cash Return on Equity =
Net Income(t) - Interest Income from Cash(t )* (1- tax rate)
Book Value of Equity(t -1) − Cash(t -1)

 Computing a ROE to compare to the cost of equity for a

firm- where the cost of equity reflects all assets owned by
the firm, conventional measure of ROE

 If the cost of equity - computed based on the riskiness of

only the operating assets of firm, non-cash ROE - better
measure of returns
Return On Equity
• One final complexity - with the use of book value
of equity
• Invested capital - almost always a positive number
• Significant number of firms - have negative book values for
equity
o Book value of equity is adjusted to reflect retained
earnings
o Firms that report years of large losses can end up with
negative book value of equity
• ROE- then a meaningless number - have to revert back to
ROIC
Other Measures
 Return on Assets (ROA) =
Operating Income(t) * (1 - tax rate)
Book Value of Total Assets(t -1)
 2 problems:
• In ROA computation - sum of assets used, thus yielding value higher
than capital invested in ROC computation as:
Total Assets = Debt + Equity + Current Liabilities
• Thus, ROA will be lower than ROC
• By itself,- not an issue if all we did was compare ROA across firms
• However, ROA cannot be compared to the cost of capital
o Since cost of capital is based on cost of debt & equity ( does not incorporate current
liabilities and other non-interest bearing liabilities)
Assessment of Accounting Meaures
 Issues :
• Accounting return estimated for single period
o Even if – is accurate assessment of that period’s performance - may not be a good
measure of returns over long term for an investment
• Use of book value of equity or capital – leaves return exposed to
accounting choices made not only in current period but to choices made
over time
o Eg. A restructuring charge taken 10 years ago can result in a lower book value of
equity and a higher return on capital for most recent year
• Any systematic quirks in accounting or tax rules - will leave imprint on the
return computations

 Most sensible course of action for an analyst is to not take accounting

earnings & book value as given
 Instead, adjust those numbers to get a better measure of returns earned
by a firm on investments
18-Jul-10 Merger, Acquisition & Corporate Valuation 19

CASH FLOW RETURNS

Cash Flow Returns
 Earnings are not cash flows
 Depreciation & amortization : Reason for difference between
earnings and cash flows
 Depreciation - accounting expense
 Depressing earnings – not a cash expense
 Interesting findings:

• Some firms : look like under performing based upon accounting

returns may look much better when looked at cash flows
• Other firms : seemingly superior performers- based upon
accounting earnings - may lag when judged based upon cash flows
Cash Earnings measures
 After-tax Operating Cash flow = EBIT (1- tax rate) + Depreciation &
Amortization
 Converting this operating cash flow measure into return : difficult
• As invested capital - used as denominator in the conventional measure
of return on capital is net of depreciation & amortization charges over
previous years
 One way to eliminate inconsistency : use of gross investment in
assets (obtained by adding back accumulated depreciation to
the net investment value) to estimate the capital investment
 Such measure of return : Cash ROIC
 Cash ROIC =
Operating Income(t) * (1 - tax rate) + Depreciation & Amortization
Gross Fixed Assets + Non - cash Working Capital
 Gross Fixed Assets = Net Fixed Assets + Accumulated Depreciation
Cash Earnings measures
 Arguments of proponents of cash flow based returns
• Cash flow returns - more meaningful estimates of what firms
generate on their existing investments

 Serious risks associated with adding back depreciation to

operating income & accumulated depreciation to asset
base
• As firms with substantial depreciation requirements often have to
reinvest this money (in capital expenditures) to keep generating
return for the long term
CFROIC Vs CFROI

• Cash flow ROIC ignores

• Inflation
• Can increase cash flow even when capital investment is same
• Life of the assets
• Capital should be taken into account only for the life of the assets

• CFROI tries to take account of two concerns

CFROI example
• The firm ABC had,
• after-tax operating cash flows of $90 million
• gross fixed assets of $650 million
• non-cash working capital of $ 100 million
• Assets are 5 years old
• inflation rate during the last 5 years = 2% a year
• remaining life for the assets is 10 years

On solving, we get IRR as 7.04%

Earnings Vs Cash Flow Returns
Is cash flow return better than accounting earnings return?
NOT necessary

• Cash ROIC measure treats the operating cash flow as a

perpetuity on existing capital invested

• CFROI measure makes more reasonable assumptions

about asset life

• It require estimates of asset life that may be difficult to

provide
18-Jul-10 Merger, Acquisition & Corporate Valuation 26

MEASUREMENT ISSUES
Measurement Issues
Are accounting earnings and cash flow, the “true”
estimates?

• Accounting misclassification of expenses

• capital expenditures that are treated as operating expenditures
• financial expenditures that are includes with operating expenses

How to fix these issues?

Misclassified Capital Expenditure
• Capitalizing R&D expenses
• Find out the amortizable life of these assets
• Collect data on R&D expenses over past 0 years (n  t )
• Value of the Research Asset =  n 1
R & Dt*
n

• Adjusted Book Value of Equity = Book Value of Equity + Value of the Research Asset

• Adjusted Operating Income = Operating Income + R & D expenses – Amortization of

Research Asset

• Adjusted Net Income = Net Income + R & D expenses – Amortization of Research

Asset
EBIT (1  t )  R & Dcurrent  R & Dammortization
• Adjusted ROC =
InvestedCa pital  Valueof Re searchAsse ts

• Adjusted ROE = NetIncome  R & Dcurrent  R & Dammortization

InvestedCa pital  Valueof Re searchAsse ts
Misclassified financial Expenditure
• The accounting treatment of leases
• There are two types of lease
• Operating lease
• Capital lease
Firms prefer to keep leases off the books, strong incentive to report all leases as
operating leases

Convert operating lease into debt (unsecured debt)

• Adjusted Debt = Debt + Present Value of Lease Commitments

• Adjusted Operating Income = Operating Income + Operating Lease

Expenses – Depreciation on leased asset

( EBIT  LeaseExpense  Depreciati onofLeased Asset )(1  t )

• Adjusted ROC =
InvestedCa pital  Pr esentValue ofOperatin gLeases
18-Jul-10 Merger, Acquisition & Corporate Valuation 30

Operating Income Adjustments

• Rationale behind adjustment

• Companies compared on the basis of continuing operations which

constitute its core business operations that generate revenue

• Adjustments done for

• Extra ordinaries
• One time Expenses
• Other Income/Expenses

• To keep things simple anything which does not form part of

continuous business operations can be stated extra ordinary
18-Jul-10 Merger, Acquisition & Corporate Valuation 31

Identification criteria
• Identifying extra ordinaries is subject to one’s
understanding of business under review

• Following issues need to be taken care of while arriving

on any judgment
• One-time expenses or income that is truly one time
• Expenses and income that do not occur every year but seem to
recur at regular intervals
• Expenses and income that recur every year but with considerable
volatility
• Items that recur every year but are positive in some years and
negative in others
18-Jul-10 Merger, Acquisition & Corporate Valuation 32

Adjustment of Capital
• Restructuring charges get classified as one time expense
with effect get adjusted

• Problem faced under such situation

• The invested capital gets reduced with effect ROIC shoots up

• A first time investor may never come to know that the company
was engaged in a mediocre investment
• Requirement is to identify all such incidents before making a call on
the kind of investments company has made and highlight any
discrepancy to maintain transparency
18-Jul-10 Merger, Acquisition & Corporate Valuation 33

Effect of Dividend and Stock Buyback

• Dividends and stock buyback have a significant effect on
the companies reported ROE

• In effect if a company resorts to dividend payout or stock

buybacks then ROIC turns out to be a better option for
evaluating the company’s performance

• To illustrate, say
• NI = 10 billion USD Book value of equity = 100 billion USD
• ROE = 10/100 = 10%
• Assuming company pays dividends worth 20 billion USD on which it
could earn 1 billion USD in interest
• The ROE in this case would be = (10-1)/(100-20) = 11.25%
18-Jul-10 Merger, Acquisition & Corporate Valuation 34

Curious Case of “Goodwill”

• Acquisition scenarios bring in what is known as “Goodwill”

• With Goodwill are associated two specific treatments

• Amortization Expense(Non Cash)

• This forms the part of P/L statement and does not effect the operating
income

• Goodwill reported as an Asset

• Inflates capital invested figure and brings down the ROIC values

• Goodwill = Acquisition Price – Book value of Assets

18-Jul-10 Merger, Acquisition & Corporate Valuation 35

Goodwill and its Components

• Following are the Goodwill Components
• Mis-measurement of value of assets in place of acquired company
• Growth assets of target company
• Value of synergy in merger
• Overpayment for target company

• In summary, goodwill can be defined as follows,

Goodwill = Market value of target firm – Book value of target firm

= (Market value of assets in place of target firm – Book
value of assets in place) + Value of growth assets of target firm
+ Value of synergy in target firm +(-) Over (under) payment for
target firm
18-Jul-10 Merger, Acquisition & Corporate Valuation 36

Goodwill and Adjustments

• Adjusted Capital invested = Capital invested - ∑Growth

Assets
• Value of growth assets cannot be included in capital invested

• So we need to figure out the value of growth assets

• Two methods that can be used for same
• Market reaction method
• Breaking the goodwill component into two parts wherein one part
represents value of growth assets
• Growth Assets Value = (Market value prior to acquisition – Book value of
acquired company)
18-Jul-10 Merger, Acquisition & Corporate Valuation 37

Cross Holdings

Minority, Passive Holding

●
Dividends received from holding recorded in income
●
Original investment included in book value

Minority, active interest

●
Income/loss from the subsidiary adjusted with net income
●
Updated book value included in book value

Majority, active interest

●
Income statements are consolidated
●
Net income adjusted for share of minority interest
●
Book value includes an updated value of equity
18-Jul-10 Merger, Acquisition & Corporate Valuation 38

Returns for the Parent Company

• ROIC

• ROE
18-Jul-10 Merger, Acquisition & Corporate Valuation 39

Returns for Consolidated Company

• ROIC

• ROE
18-Jul-10 Merger, Acquisition & Corporate Valuation 40

Forecasting Future Returns

• Historical returns factors to be considered

Volatility Average
in Effect of vs.
historical Scale Marginal
returns Returns
18-Jul-10 Merger, Acquisition & Corporate Valuation 41

Involved Volatility

Return Return volatility

volatility is higher for
younger, high
increases with growth firms than
the level of it is for more
returns mature firms

The returns on
Investment
equity are
return volatility
more volatile
is correlated
than the
with stock
returns on
capital
return volatility
18-Jul-10 Merger, Acquisition & Corporate Valuation 42

The Scale Effect

Average vs Marginal
• Marginal return tells about how good/bad were the
investments made in the recent period
• Focus on just the new investments made in a particular
period
• Average returns more stable and persistent than marginal
returns on capital
• Difference between them widens as the company
becomes larger
Industry and sector averages
• Firms growth is dependent on the sector
• Mature sector implies difficult to sustain high growth
• Difference in returns across the sectors vary due to the
following reasons:
• Life cycle
• Accounting inconsistencies
• Barriers to entry
Other reasons for difference in returns

• Luck

• Management quality

• Competitive advantages
Excess returns and competitive advantages
• Excess returns attract new competitors and hence putting
pressure on existing returns
• In competitive markets firms have to perceive an
opportunity to generate excess returns for extended
periods
• Sustainability of excess returns:
• excess returns are far more sustainable than the high growth rates
• revenue growth tends to revert quickly to average level, returns on
invested capital can remain high for the extend3ed periods
Forecasting returns
• Most challenging part of valuation
• Depends upon the companies competitive advantages
and sector barriers to entry

• Note: the length of the short term and transition periods

will be determined by the fact that the competitive
advantage has an explicit life.
Terminal value

• Expected growth rate in perpetuity can’t exceed the

economy growth rate

• For growth companies have to reinvest

Comparison of measures of investment returns
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