8 chapter return on invested capital. joint analysis is where one measure is assessed relative to...
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• 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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11.25
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22.25
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33.25
3.53.75
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Profit margins %
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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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0.5
1
1.5
2
2.5
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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%