Ch08PPTs.ppt

8/14/2019 Ch08PPTs.ppt

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8CHAPTER

Return on Invested

Capital


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Joint analysis is where one measure isassessed relative to another

Return on invested capital (ROI) is an important joint analysis

Return on Invested CapitalImportance of Joint Analysis


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Return on Invested CapitalROI Relation

ROI relates income, or other performance measure, toa company s level and source of financing

ROI allows comparisons with alternative investment

opportunities Riskier investments are expected to yield a higherROI

ROI impacts a company s abilityto succeed, attract financing,repay creditors,and reward owners


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Return on Invested CapitalApplication of ROI

(1) evaluating

managerialeffective-ness

(2)assessing

profitability

(3)earningsforecasting

(4)planning andcontrol

ROI is applicable to:


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Return on Invested CapitalEvaluating Managerial Effectiveness

Management isresponsible for allcompany activities

ROI is a measure of managerialeffectiveness in business activities

ROI depends on the skill, resourcefulness,ingenuity, and motivation of management


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Return on Invested CapitalMeasuring Profitability

ROI is an indicator of companyprofitability

ROI relates key summarymeasures: profits with financing

ROI conveys return on investedcapital from different financing perspectives


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Return on Invested CapitalAssists in Forecasting Earnings

ROI links past, current, and forecasted earnings withinvested capital

ROI adds disciplineto forecasting

ROI helps identifyoptimisticor pessimisticforecasts

ROI aids in evaluating prior forecast performance


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Return on Invested CapitalFor Planning and Control

ROI assists managers with:

Planning Budgeting Coordinating activities Evaluating opportunities Control


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Components of ROIDefinition

Return on invested capital is defined as:

capitalInvestedIncome


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Components of ROIInvested Capital Defined

No universal measureof invested capital

exists

Different measures ofinvested capital reflectdifferent financiersperspectives


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Components of ROIAlternative Measures of Invested Capital

Five Common Measures:

Total Assets

Long-Term Debt Plus Equity Equity Market Value of Invested Capital

Investor Invested Capital


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Components of ROITotal Assets

Perspective is that of its totalfinancing base

Called return on assets ROA)

ROA:measures operating efficiency/

performance

reflects return from all financingdoes not distinguish return byfinancing sources


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Some adjust this invested capitalbase for:

1. Unproductive Assets

2. Intangible Assets

3. Accumulated Depreciation


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Unproduc t ive Asset A d jus tmen t Assumes management not responsible for

earning a return on capital not in operations Excludes idle plant, facilities under

construction, surplus plant, surplusinventories, surplus cash, and deferredcharges from invested capital

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


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In tangib le As se t Adjus tm ent

Assumes skepticism of intangible assetvalues

Excludes intangible assets frominvested capital

Adjustment is not valid as:Lack of information or increased

uncertainty does not justify exclusion


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Acc um ulated Deprec iat ion Ad jus tment 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 performanceof the entire company

It is inconsistent with computation of income net ofdepreciation expense Acquisitions of new depreciable assets offset a decliningcapital base It fails to recognize increased maintenance costs as assets

age


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Components of ROILong-Term Debt Plus Equity Capital

Perspective is that of the two mainsuppliers of long-term financing

long-term creditors and equityshareholders

Referred to as long-term

capitalization Excludes current liability

financing


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Components of ROI

Equity Capital

Perspective is that of equityholders

Captures the effect of leverage(debt) capital on equity holderreturn

Excludes all debt financing andpreferred equity


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Components of ROI

Market Value of Invested Capital

Assumes certain assets notrecognized in financial statements

Uses the market value of investedcapital (debt and equity)


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Components of ROI

Investor Invested Capital

Perspective is that of the individualinvestor

Focus is on individual shareholder, notthe company

Uses the purchase price of securities as

invested capital


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Components of ROIComputing Invested Capital

Usually computed using average capital available for the period

Typically add beginning andending invested capital amountsand divide by 2

More accurate computation is toaverage interim amounts quarterly or monthly


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Components of ROIIncome Defined

Definition of income return) depends on definition of investedcapital

Measures of income in computing return on invested capital mustreflect all applicable expenses from the perspective of the capital

contributors Income taxes are valid deductions in computing income for returnon 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


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Components of ROIAdjustments to Invested Capital and Income Numbers

Many accounting numbers require analyticaladjustment see prior chapters

Some numbers not reported in financialstatements need to be includedSuch adjustments are necessary for effectiveanalysis of return on invested capital


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Components of ROIReturn on Assets -- ROA

2assets)totalEndingassetstotal(Beginning

incomeininterestMinorityrate)Tax(1expenseInterestincomeNet


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Components of ROIReturn on Long-Term Debt plus Equity

equity)Averagedebtterm-long(AverageincomeininterestMinorityrate)Tax(1expenseInterestincomeNet

[Also called return on long-term capitalization]


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Components of ROIReturn on Common Equity -- ROCE

Net income - Preferred dividends

Total common shareholders equity

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

ROCE is approximated by

Basic earnings per shareBook value per share


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Analyzing Return on Assets--ROA

Disaggregating ROA

AssetsSales

SalesIncome

AssetsIncome

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

Return on assets = Profit margin x Asset turnover


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Relation Between Profit Margin and Asset Turnover

Profit margin and asset turnover are interdependent

Relation between Profit Margin, Asset Turnover, andReturn on Assets

00.25

0.50.75

1

1.251.5

1.752

2.252.5

2.753

3.253.5

3.75

-2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

Profit margins %

A s s e

t t u r n o v e r

A

DE

GF

HI

B

C

YK

J

L

N

P

X

M

O


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

Profit Margin, Asset Turnonver, and Re turn on Assets for SelectedIndustries

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

5.5

6

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 %

A s s e t t u r n o v e r

ROA = 5% Food Stores

Agriculture Amusements

Health Services Metals Petroleum

Air Transportation Paper

Building Materials Construction

Chemicals Fisheries

Tobacco Oil & Gas

Hotels

Museums

Real Estate

Auto Dealers

Wholesale Trade Builders

Wholesale-Nondurables

Transportation Service


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Asset Turnover Analysis

Asset turnover measures the

intensity with which companies utilizeassets

Relevant measure is the

amount of salesgenerated


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Sales to Cash:

Reflects trade-off between liquidity and accumulation of low-returnfunds

Sales to Receivables: Reflects trade-off between increased sales and accumulationof funds in receivables

Sales to Inventories: Reflects trade-off between funds accumulated in inventory andthe potential loss of current and future sales

Sales to Fixed Assets: Reflects trade-off between fixed asset investments havinghigh break-even points and investments in moreefficient, productive assets with high sales potential

Sales to Other Assets: Reflects trade-off betweenassets held for current and future sales and accumulationof funds in higher risk assets

Sales to Current Liabilities: Reflects a relation between sales andcurrent trade liabilities

Analyzing Return on Assets--ROADisaggregating Asset turnover


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...nk)(1

)1ntBV(kntNI ...2k)(1

)1tBV(k2tNI k)(1

)tBV(k1tNI tBVtV

...nk)(11ntk)BVnt(ROCE ...

2k)(11tk)BV2t(ROCE

k)(1tk)BV1t(ROCE tBVtV

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 commonequity

This can be restated in terms of future ROCE:


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Disaggregating ROCE

Adjusted profit margin: portion of each sales dollar remaining for commonshareholders after providing for all costs and claims (including preferreddividends)

Asset turnover (utilization): measures effectiveness in generating sales fromassets

Leverage* : measures the proportion of assets financed by commonshareholders

*Also called financial leverage and common leverage .

ROCE = Adjusted profit margin Asset turnover Leverage

equitycommon Average

assetsAverage

assets

AverageSales

SalesdividendsPreferred

incomeNet

equitycommon

AveragedividendsPreferred

incomeNet


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


Further Disaggregation of Adjusted Profit Margin

Pre-tax adjusted profit margin: measure of operatingeffectiveness

Retention rate: measure of tax-management effectiveness

dividendsPreferredearningstax-PredividendsPreferredincomeNet

SalesdividendsPreferred earningstax-Pre

SalesdividendsPreferredincomeNet


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ROCE = [(EBIT profit margin Asset turnover) Interestburden] Leverage Retention rate

EBIT is earnings (income) before interest and taxes (andbefore 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


Further Disaggregation of ROCE


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Assessing Equity Growth

equityrsstockholdecommonAveragepayoutDividenddividendsPreferredincomeNet =rategrowthEquity

Assumes earnings retention an d aconstant dividend payout

Assesses common equitygrowth rate throughearnings retention


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Assessing Equity Growth

Assumes internal growthdepends on bo th earningsretention and return earnedon the earnings retained

rate)Payout(1ROCE=rategrowthequityeSustainabl


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Analyzing Return on Common Equity--ROA

Leverage and ROCE

Leverage refers to the extent of invested capitalfrom other than common shareholders

If suppliers of capital (other than commonshareholders) receive less than ROA, thencommon shareholders benefit; the reverseoccurs when suppliers of capital receive morethan ROA

The larger the difference in returns betweencommon equity and other capital suppliers, themore successful (or unsuccessful) is the tradingon the equity


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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 CommonEquity

Current 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 5,334Preferred 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%


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Return on Shareholders Investment --ROSI

(cost) priceSharereinvestedearningsof ueMarket valDividends

ROSI

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Ch08PPTs.ppt