Return on Invested

Capital

8
CHAPTER
 Return on Invested Capital
Importance of Joint Analysis

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

•• Return
Return on
on invested
invested capital
capital (ROI)
(ROI) is
is an
an important
important
joint
joint analysis
analysis
Return on Invested Capital
ROI Relation
••ROI
ROI relates
relatesincome,
income, or
orother
otherperformance
performancemeasure,
measure, to
to
aacompany’s
company’slevel
level and
andsource
sourceof
offinancing
financing
••ROI
ROI allows
allowscomparisons
comparisonswith
withalternative
alternativeinvestment
investment
opportunities
opportunities

••Riskier
Riskierinvestments
investmentsare
areexpected
expectedto
toyield
yieldaahigher
higher
ROI
ROI

••ROI
ROI impacts
impactsaacompany’s
company’sability
ability
to
tosucceed,
succeed, attract
attractfinancing,
financing,
repay
repaycreditors,and
creditors,andreward
rewardowners
owners
Return on Invested Capital
Application of ROI
ROI is applicable to:
(1)
evaluating (2)
managerial assessing
effective- profitability
ness

(3) (4)
earnings planning and
forecasting control
 Return on Invested Capital
Evaluating Managerial Effectiveness

•• Management
Management is is
responsible
responsible for
for all
all
company
company activities
activities

•• ROI
ROI is
is aa measure
measure of
of managerial
managerial
effectiveness
effectiveness in
in business
business activities
activities

•• ROI
ROI depends
depends onon the
the skill,
skill, resourcefulness,
resourcefulness,
ingenuity,
ingenuity, and
and motivation
motivation of of management
management
 Return on Invested Capital
Measuring Profitability

•• ROI
ROI is
is an
an indicator
indicator of
of company
company
profitability
profitability

•• ROI
ROI relates
relates key
key summary
summary
measures:
measures: profits
profits with
with financing
financing

•• ROI
ROI conveys
conveys return
return on
on invested
invested
capital
capital from
from different
different financing
financing perspectives
perspectives
 Return on Invested Capital
Assists in Forecasting Earnings

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

•• ROI
ROI adds
addsdiscipline
discipline
to
toforecasting
forecasting

•• ROI
ROI helps
helpsidentify
identify
optimisticor
optimisticorpessimistic
pessimistic
forecasts
forecasts

•• ROI
ROI aids
aidsin
inevaluating
evaluatingprior
priorforecast
forecastperformance
performance
 Return on Invested Capital
For Planning and Control

ROI
ROI assists
assists managers
managers with:
with:

•• Planning
Planning
•• Budgeting
Budgeting
•• Coordinating
Coordinating activities
activities
•• Evaluating
Evaluating opportunities
opportunities
•• Control
Control
 Components of ROI
Definition

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

Income
Invested capital
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
Perspectiveisisthat
thatof
ofits
itstotal
total
financing
financingbase
base
Called return
•• Called return on
on assets
assets (ROA)
(ROA)

ROA:
ROA:
measures
 measuresoperating
operatingefficiency/
efficiency/
performance
performance
reflects
 reflectsreturn
returnfrom
fromall
all financing
financing
does
 doesnot
notdistinguish
distinguishreturn
returnby by
financing
financingsources
sources
 Components of ROI
Total Assets

Some
Some adjust
adjust this
this invested
invested capital
capital
base
base for:
for:
1.
1. Unproductive
Unproductive Assets
Assets

2.
2. Intangible
Intangible Assets
Assets

3.
3. Accumulated
Accumulated Depreciation
Depreciation
 Components of ROI
Total Assets
Unproductive
UnproductiveAssetAssetAdjustment
Adjustment
••Assumes
Assumesmanagement
management not not responsible
responsiblefor
for
earning
earningaareturn
returnononcapital
capitalnotnot in
inoperations
operations
•• Excludes
Excludesidle
idleplant,
plant, facilities
facilitiesunder
under
construction,
construction, surplus
surplusplant,
plant, surplus
surplus
inventories,
inventories, surplus
surpluscash,
cash, andanddeferred
deferred charges
charges
from
frominvested
investedcapital
capital

Adjustment
Adjustment isisnot
not valid
validas
asitit fails
failsto:
to:
recognize
recognizethat
that management
management has hasdiscretion
discretion
over
overall
allinvestment
investment
assess
assessoverall
overallmanagement
management effectiveness
effectiveness
 Components of ROI
Total Assets

Intangible
IntangibleAsset
AssetAdjustment
Adjustment

•• Assumes
Assumes skepticism
skepticism of
of intangible
intangible asset
asset
values
values
•• Excludes
Excludes intangible
intangible assets
assets from
from
invested
investedcapital
capital

Adjustment
Adjustmentisisnot
notvalid
validas:
as:
 Lack
Lackof
ofinformation
informationor orincreased
increased
uncertainty
uncertaintydoes
doesnot
notjustify
justifyexclusion
exclusion
 Components of ROI
Total Assets
Accumulated
AccumulatedDepreciation
DepreciationAdjustment
Adjustment
•• Assumes
Assumesplant
plantassets
assetsmaintained
maintainedininprime
prime condition
condition
•• Assumes
Assumesinappropriate
inappropriateto
toassess
assessreturn
returnrelative
relativeto
tonet
netassets
assets
•• Concern
Concernwith
withaadecreasing
decreasinginvested
investedcapital
capitalbase
base
•• Includes
Includesan
anaddback
addbackfor
foraccumulated
accumulateddepreciation
depreciationonon
depreciable
depreciableassets
assets
Adjustment
Adjustmentis isnot
notvalid
validas:
as:
ROA
ROAanalysis
analysisfocuses
focuseson onthe
theperformance
performance
ofofthetheentire
entirecompany
company
ItIt is
is inconsistent
inconsistent with
with computation
computation of
of income
income net
net of
of
depreciation
depreciationexpense
expense
Acquisitions
Acquisitions of of new
new depreciable
depreciable assets
assets offset
offset aa declining
declining
capital
capitalbasebase
ItItfails
failsto
torecognize
recognizeincreased
increasedmaintenance
maintenancecosts
costsas asassets
assets
age
age
 Components of ROI
Long-Term Debt Plus Equity Capital

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

•• Referred
Referred to
to as
as long-term
long-term
capitalization
capitalization

•• Excludes
Excludes current
current liability
liability
financing
financing
 Components of ROI
Equity Capital

•• Perspective
Perspective is
is that
that of
of equity
equity
holders
holders

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

•• Excludes
Excludes all
all debt
debt financing
financing and
and
preferred
preferred equity
equity
 Components of ROI
Market Value of Invested Capital

•• Assumes
Assumes certain
certain assets
assets not
not
recognized
recognized in
in financial
financial statements
statements

•• Uses
Uses the
the market
market value
value of
of invested
invested
capital
capital (debt
(debt and
and equity)
equity)
 Components of ROI
Investor Invested Capital

•• Perspective
Perspective is
is that
that of
of the
the individual
individual
investor
investor
•• Focus
Focus is
is on
on individual
individual shareholder,
shareholder, not
not
the
thecompany
company
•• Uses
Usesthe
thepurchase
purchaseprice
priceofofsecurities
securitiesas
as
invested
investedcapital
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
Manyaccounting
accountingnumbers
numbersrequire
requireanalytical
analytical
adjustment—see
adjustment—seeprior
priorchapters
chapters

 Some
Somenumbers
numbersnot
notreported
reportedin infinancial
financial
statements
statementsneed
needtotobe
beincluded
included

 Such
Suchadjustments
adjustmentsarearenecessary
necessaryfor foreffective
effective
analysis
analysisof
ofreturn
returnon
oninvested
investedcapital
capital
 Components of ROI
Return on Assets -- ROA

Net income  Interest expense (1 Tax rate)  Minority interest in income

(Beginning total assets  Ending total assets)  2
 Components of ROI
Return on Long-Term Debt plus Equity

Net income Interest expense (1Tax 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
Netincome
income--Preferred
Preferreddividends
dividends
Total
Totalcommon
commonshareholders’
shareholders’equity
equity

[When
[WhenROCE
ROCEis ishigher
higherthan
thanROA,
ROA,ititoften
oftenreflects
reflectsfavorable
favorable
impacts
impactsof
ofleverage]
leverage]

ROCE
ROCEis
isapproximated
approximatedby
by

Basic
Basicearnings
earningsper
pershare
share
Book
Bookvalue
valueper
pershare
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
Asset turnover

2.75
A
2.5
2.25 D Y
2 E K L
1.75 B F
M
1.5 G
N X
1.25 H
1 I O
J
0.75
C 0.5
P
0.25
0
-2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

Profit margins %
 Analyzing Return on Assets--ROA
Relation Between Profit Margin and Asset Turnover
Profit Margin, Asset Turnonver, and Return on Assets for Selected
Industries
6
ROA = 5%
5.5
Food Stores
5
Transportation Service
4.5
Asset turnover

4
Wholesale-Nondurables
Auto Dealers
3.5
Builders
3 Wholesale Trade
Building Materials
2.5
Paper Construction
2 Air Transportation Chemicals Tobacco
1.5 Petroleum Metals Fisheries Oil & Gas
Health Services
1 Hotels Real Estate
Amusements
0.5 Agriculture
Museums
0
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

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

NI  (k  BV ) NI  (k  BV ) NI  (k  BV )
V  BV  t 1 t  t 2 t 1  ...  t n t n  1  ...
t t (1  k) (1  k) 2 (1  k) n

This can be restated in terms of future ROCE:

(ROCE  k)BV (ROCE  k)BV (ROCE  k)BV

V  BV  t 1 t  t 2 t 1  . . .  t n t n  1  ...
t t (1  k) (1  k) 2 (1  k) n

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

Net income  Net income  Average

Preferred dividends Preferred dividends assets
  Sales 
Average Sales Average Average
common equity assets 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
Adjusted profit
profit margin
margin == Pre-tax
Pre-tax adjusted
adjusted profit
profit
margin
margin xx Retention
Retention rate
rate

Net income  Pre-tax earnings  Net income 

Preferred dividends  Preferred dividends  Preferred dividends
Sales Sales Pre-tax earnings 
Preferred dividends

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
ROCE==[(EBIT
[(EBITprofit
profitmargin
margin××Asset
Assetturnover)
turnover)––Interest
Interest
burden]
burden]××Leverage
Leverage××Retention
Retentionrate
rate

•• EBIT
EBIT isis earnings
earnings (income)
(income) before
before interest
interest and
and taxes
taxes (and
(and
before
beforeanyanypreferred
preferreddividends)
dividends)
•• EBIT
EBITprofit
profit margin
marginisisEBIT
EBITdivided
dividedbybysales
sales
•• Interest
Interest burden
burden isis interest
interest expense
expense divided
divided by
by average
average
assets
assets

This
Thisdisaggregation
disaggregationhighlights
highlightseffects
effectsof
of both
bothinterest
interest and
and
taxes
taxeson
onROCE
ROCE
Analyzing Return on Common Equity--ROCE
Assessing Equity Growth

Equity growth rate = Net income  Preferred dividends  Dividend payout

Average common stockholders’ equity

•• Assumes
Assumesearnings
earningsretention
retention and
andaa
constant
constantdividend
dividend payout
payout

•• Assesses
Assessescommon
commonequity
equity
growth
growthrate
ratethrough
through
earnings
earnings retention
retention
Analyzing Return on Common Equity--ROCE
Assessing Equity Growth

Sustainable equity growth rate = ROCE  (1Payout rate)

Assumes
Assumesinternal
internal growth
growth
depends
depends onon both
both earnings
earnings
retention
retentionand
andreturn
returnearned
earned
on
onthe
theearnings
earningsretained
retained
Analyzing Return on Common Equity--ROA
Leverage and ROCE

•• Leverage
Leverage refers
refers to
to the
the extent
extent of
of invested
invested capital
capital
from
fromother
otherthan
thancommon
commonshareholders
shareholders

•• IfIf suppliers
suppliers of
of capital
capital (other
(other than
than common
common
shareholders)
shareholders) receive
receive less
less than
than ROA,
ROA, then
then
common
common shareholders
shareholders benefit;
benefit; the
the reverse
reverse
occurs
occurs when
when suppliers
suppliers ofof capital
capital receive
receive more
more
than
thanROAROA

•• The
Thelarger
largerthe
thedifference
differencein
inreturns
returnsbetween
between
common
commonequity
equityand
andother
othercapital
capital suppliers,
suppliers, the
the
more
moresuccessful
successful (or
(orunsuccessful)
unsuccessful)isisthe
thetrading
trading
on
onthe
theequity
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 (Detracting
Supplied Supplied at 5.677% Financiers from) Return on Common
Equity
(a)
Current liabilities $ 176,677 $ 10,030 $ 412 $ 9,618
Long-term debt 353,985 20,096 11,817(b) 8,279
Deferred taxes 93,962 5,334 none 5,334
(c)
Preferred stock 41,538 2,358 2,908 (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

Dividends  Market value of earnings reinvested

ROSI 
Share price (cost)

s
nd
ivide
D