Returns on Capital and Equity for Entire Firms

The discussion of returns on equity and capital has so far revolved around individual projects. It is possible, however, to calculate the return on equity or capital for an entire firm, based upon its current earnings and book value. The computation parallels the estimation for individual projects but uses the values for the entire firm:

Return on Capital (ROC or ROIC) = Return on Equity =

(Book Value of Debt + Book Value of Equity) Net Income

Book Value of Equity

We use book value rather than market value because it represents the investment (at least as measured by investments) in existing investments. This return can be used as an approximate measure of the returns that the firm is making on its existing investments or assets, as long as the following assumptions hold:

1. The income used (operating or net) is income derived from existing projects and is not skewed by expenditures designed to provide future growth (such as R&D expenses) or one-time gains or losses.

2. More importantly, the book value of the assets used measures the actual investment that the firm has in these assets. Here again, stock buybacks and goodwill amortization can create serious distortions in the book value.5

3. The depreciation and other non-cash charges that usually depress income are used to make capital expenditures that maintain the existing asset's income earning potential.

If these assumptions hold, the return on capital becomes a reasonable proxy for what the firm is making on its existing investments or projects, and the return on equity becomes a proxy for what the equity investors are making on their share of these investments.

With this reasoning, a firm that earns a return on capital that exceeds it cost of capital can be viewed as having, on average, good projects on its books. Conversely, a firm that earns a return on capital that is less than the cost of capital can be viewed as having, on average, bad projects on its books. From the equity standpoint, a firm that earns a return on equity that exceeds its cost of equity can be viewed as earnings "surplus returns" for its stockholders, while a firm that does not accomplish this is taking on projects that destroy stockholder value.

Illustration 5.9: Evaluating Current Investments

In table 5.10, we have summarized the current returns on capital and costs of capital for Disney, Aracruz and Bookscape. The book values of debt and equity at the beginning of the year (2003) were added together to compute the book value of capital invested, and the operating income for the most recent financial year (2003) is used to compute the return on capital.6 Considering the issues associated with measuring debt and cost of capital for financial services firms, we have not computed the values for Deutsche Bank:

5 Stock buybacks and large write offs will push down book capital and result in overstated accounting returns. Acquisitions that create large amounts of goodwill will push up book capital and result in understated returns on capital.

6 Some analysts use average capital invested over the year, obtained by averaging the book value of capital at the beginning and end of the year. By using the capital invested at the beginning of the year, we have assumed that capital invested during the course of year is unlikely to generate operating income during that year.

Table 5.10: Return on Capital and Cost of Capital Comparison
Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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