Why does the return on assets differ between Company A and Company B?
ROA= Net income/total assets
Companies that hold less than 20% of another company (or subsidiary) only record income when dividends are paid (BUSN company accounting).
Therefore, profits will be under reported. This causes return on assets to be distorted downwards.
Since Company B has $50 million in equity investments, but no corresponding income, its ROA is lower than Company A.
ROA is readily used to
compare firms in the same industry and can show the efficiency of a firm in using its assets to generate earnings.
An analyst or investor would prefer this number to be higher because that would indicate that the
company is earning more with less.
Return on Equity (ROE) is calculated as
net income divided by shareholder’s equity.
Used in comparing firms with the same capital structure, ROE reveals the level of profitability which a firm realizes by the money which was given to them by equity investors.
Return on Invested Capital (ROIC) tells an analyst
net operating profits after taxes (NOPAT) divided by invested capital.
• ROIC tells an analyst how efficient the firm was in investing capital in profitable investments. This invested capital can go into anywhere from buildings to other companies. The upside to this ratio is that it can be used to compare firms with different capital structures.
profits generated from the company’s core operations after subtracting the income taxes related to the core operations.
When we calculate NOPLAT, interest is not subtracted from operating profit, because interest is considered a payment to the company’s financial investors, not an operating expense.
Net investment is
the increase in invested capital from one year to the next:
• Net Investment = Invested Capitalt+1 − Invested Capital
Free cash flow (FCF)
cash flow generated by the core operations of the business after deducting investments in new capital
FCF = NOPLAT + Noncash Operating Expenses − Investment in Invested Capital
invested capital can be calculated using the operating method
operating assets minus operating liabilities
debt plus equity
From an investing perspective, total funds invested equals
invested capital plus nonoperating assets eg such as marketable securities, prepaid pension assets, nonconsolidated subsidiaries, and other long-term investments.
From the financing perspective, total funds invested equals
debt and its equivalents, plus equity and its equivalents.
Why does the return on equity differ between Company A and Company C?
ROE= Net incoem/ equity
Company C's return on equity outpaces both Company A and Company B because the company uses leverage.
OA− OL= Invested Capital = Debt + Equity
Leverage will magnify operating results. Leverage makes good results look great, but can bankrupt companies with poor performance.
= working capital + PPE
Operating current asset
Operating current liabilities
Invested capital = working capital + PPE
Operating working capital = operating current assets - operating current liabilities.
Operating current assets comprise all current assets necessary for the operation of the business, including working cash balances, trade accounts receivable, inventory, and prepaid expenses.
Operating current liabilities include those liabilities that are related to the ongoing operations of the firm. The most common operating liabilities are those related to suppliers (accounts payable), employees (accrued salaries), customers (deferred revenue), and the government (income taxes payable).
Does including excess cash as part of invested capital distort the ROIC upward or downward? Why?
is unnecessary for core operations. Rather than mix excess cash with core operations, analyze and value excess cash separately. Given its liquidity and low risk, excess cash will earn very small returns. Failing to separate excess cash from core operations will incorrectly depress the company’s apparent ROIC
Invested capital represents
In addition to invested capital,
Invested capital represents the capital necessary to operate a company’s core business.
In addition to invested capital, companies can also own nonoperating assets. Nonoperating assets include excess cash and marketable securities, certain financing receivables (e.g., credit card receivables), nonconsolidated subsidiaries, and excess pension assets. Summing invested capital and nonop- erating assets leads to total funds invested.
is the ROIC sustainable?
Life cycle of its business or main products
• Longer cycle is better
• Stage of the life cycle: Rising, booming, or sunset industry?
• Persistence of competitive advantage
• Network entrenchment?
• Entry and competition
• Branding value
• Potential for product renewal
• Sustainability of “innovation”? • New market?
ROIC decomposition underlying ‘value drivers’
Value creation could be distilled to 4 core value drivers:
1. Revenue growth–determines ‘size’ of the company
2. Operating margin–how much profit generated fromrevenue
3. Capital efficiency–how much capital required to support operations
4. Cost of capital–the required rate of return/discountrate
why should we focus on ROIC and value drivers
Drivers of Revenue growth
• Growth from invested capital performance
- Portfolio momentum, maintain or expanding market share
• Growth from new investment
- • Assets investment or financial transaction ‐‐Mergers and acquisitions
• Questions to consider
• What is the main growth strength of the company that you evaluate?
• Any potential M&A or other assets acquisition or new line investment?
Explain difficulty in sustaining growth
- When the firm growth bigger, larger new investment project is required to achieve the same growth rate.
• Constrains from the market size and demand
• Existing portfolio/product also has its own life cycle
Difficulty in sustaining growth
Q to consider in valuation
• What is the company’s position now in term of size, product age?
• What is the constrains from the current market?
- Any potential new market? New product/line?
• Avoid over targeting
Relation between growth, returns, and value creation
q to consider
• Could new product/line be introduced to generate growth (& return > WACC)?
• Can the existing customers buy more?
• Can the firm attract new customers?
• Any incremental innovation?
• Any positive synergy acquisition?