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A Note on ROI
The return on investment is often based on the firm’s return on capital on EXISTING
investments, where the book value of invested capital (= the book value of debt + the book
value of equity) is assumed to measure the capital invested in these investments. Implicitly,
we assume that the current accounting return on invested capital is a good measure of the
‘true’ returns earned on existing investments and that this return is a good proxy for returns
that will be made on FUTURE investments. This assumption, of course, is open to question
for the following reasons:
The book value of invested capital might not be a good measure of the capital
invested in EXISTING investments, since it reflects the historical cost of these
assets and accounting decisions on depreciation. When the book value understates
the capital invested, the return on invested capital will be overstated; when book
value overstates the capital invested, the return on invested capital will be
understated. This problem is exacerbated if the book value of invested capital is not
adjusted to reflect the value of the (internally-developed) R&D assets or the
capitalized value of operating leases.
The operating income, like the book value of invested capital, is an accounting
measure of the earnings made by a firm during a period. All the problems in using
unadjusted operating income are for example, (i) the accounting treatment of
expensing off the operating leases, which from finance perspective, they are similar
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to the finance or capital leases; (ii) accounting treatment to expense off R&D
expenses to profit and loss, though clearly they are designed to provide benefits
multiple periods into the future (and thus, should be categorized as capital
expenditures); (iii) the incidence of one-time or irregular income and expenses.
Even if the operating income and book value of the invested capital are measured
correctly, the return on invested capital on EXISTING investments may not be equal
to the MARGINAL return on invested capital that the firm expects to make on NEW
investments, especially as the company goes further into the future.
Given these concerns, the valuation analysts should consider NOT ONLY the company’s
current return on invested capital, but also (i) any trends in that historical return, as well as
(ii) the industry average return on invested capital.
Note that in valuation context, we base our estimate of a company’s value on EXPECTED
FUTURE cash flows, not CURRENT cash flows. It is the FORECASTS OF EARNINGS,
NET CAPITAL EXPENDITURES, and WORKING CAPITAL that will yield these
EXPECTED cash flows. This will require us to estimate the growth rate in all those inputs
that generate the EXPECTED cash flows. Since all that we are talking about is about
FUTURE, EXPECTED, FORECAST, then the return on invested capital should be
MARGINAL return on invested capital, not the ACTUAL or AVERAGE return on capital
earned on the ACTUAL reinvestment. Given that the companies tend to accept their most
attractive investment first and their less attractive investments later, the AVERAGE returns
on invested capital will tend to be greater than the MARGINAL returns on capital. Thus, a
company with a return on invested capital of 20% and a cost of capital of 15% may really
be earning only 12% on its MARGINAL or INCREMENTAL projects. In addition, the
MARGINAL return on invested capital will be much lower if the increase in the reinvestment
rate is substantial. Thus, the analysts should be cautious about assuming large increases
in the reinvestment rate while keeping the current return on invested capital constant.
Reference:
Damodaran, Aswath. Corporate Finance: Theory and Practice. Second edition. 2001. John
Wiley & Sons,Inc. Page 752, 758, 799.
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