8
CHAPTER
Return on Invested
Capital
? Joint analysis is where one measure is
assessed relative to another
? Return on invested capital (ROI) is an important
joint analysis
Return on Invested Capital
Importance 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
?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 Capital
Application of ROI
(1)
evaluating
managerial
effective-
ness
(2)
assessing
profitability
(3)
earnings
forecasting
(4)
planning and
control
ROI is applicable to,
Return on Invested Capital
Evaluating 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
Return on Invested Capital
Measuring 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
Return on Invested Capital
Assists in Forecasting Earnings
? ROI links past,current,and forecasted earnings with
invested capital
? ROI adds discipline
to forecasting
? ROI helps identify
optimisticor pessimistic
forecasts
? ROI aids in evaluating prior forecast performance
Return on Invested Capital
For Planning and Control
ROI assists managers with,
? Planning
? Budgeting
? Coordinating activities
? Evaluating opportunities
? Control
Components of ROI
Definition
Return on invested capital is defined as,
c a p i t a l I n v e s t e d
I n c o m e
Components of ROI
Invested Capital Defined
? No universal measure
of invested capital
exists
? Different measures of
invested capital reflect
different financiers’
perspectives
Components of ROI
Alternative Measures of Invested Capital
Five Common Measures,
? Total Financing (Total Debt plus
Total Equity)
? Long-Term Debt Plus Equity
? Equity
? Market Value of Invested Capital
? Investor Invested Capital
Components of ROI
Total Debt and Equity Capital
? 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 ROI
Total Debt and Equity Capital
Some adjust this invested
capital base for,
1,Unproductive Assets
2,Intangible Assets
3,Accumulated Depreciation
Components of ROI
Total Debt and Equity Capital
Unproductive Asset Adjustment
? Assumes management not responsible for
earning a return on capital not in operations
? Excludes idle plant,facilities under
construction,surplus plant,surplus
inventories,surplus cash,and deferred
charges from invested capital
Adjustment is not valid as it fails to,
? recognize that management has discretion
over all investment
? assess overall management effectiveness
Components of ROI
Total Debt and Equity Capital
Intangible Asset Adjustment
? Assumes skepticism of intangible asset
values
? Excludes intangible assets from
invested capital
Adjustment is not valid as,
? Lack of information or increased
uncertainty does not justify exclusion
Components of ROI
Total Debt and Equity Capital
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
? Includes an addback for accumulated depreciation on
depreciable assets
Adjustment is not valid as,
? ROA analysis focuses on the performance
of the entire company
? 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 ROI
Long-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 long-term
capitalization
? Excludes current liability
financing
Components of ROI
Equity Capital
? Perspective is that of equity
holders
? Captures the effect of leverage
(debt) capital on equity holder
return
? 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)
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
Components of ROI
Computing 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 ROI
Income 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 debt plus equity 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 ROI
Adjustments 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
Components of ROI
Return on Assets (Debt and Equity) -- ROA
2 a s s e t s ) t o t a l E n d i n g a s s e t s t o t a l ( B e g i n n i n g
i n c o m e in i n t e r e s t M i n o r i t y r a t e )T a x (1 e x p e n s e I n t e r e s t i n c o m e N e t
??
???
Components of ROI
Return on Long-Term Debt plus Equity
e q u it y ) A v e r a g ed e b t t e r m-lo n g ( A v e r a g e
in c o m e inin t e r e s t M in o r i t yr a t e ) T a x(1 e x p e n s eIn t e r e s t in c o m eN e t
?
???
[Also called return on long-term capitalization]
Components of ROI
Return on Common Equity -- ROCE
Net income - Preferred dividends
Total common shareholders’ equity
[When ROCE is higher than ROA,it often reflects
favorable impacts of leverage]
ROCE is approximated by
Basic earnings per share
Book value per share
Analyzing Return on Assets--ROA
Disaggregating ROA
A s s e t s
S a l e s
S a l e s
I n c o m e
A s s e t s
I n c o m e ??
Profit margin,measures profitability relative to sale
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
R e l a ti o n b e tw e e n Pr o fi t M a r g i n,A s s e t T u r n o v e r,a n d
R e tu r n o n A s s e ts
0
0, 2 5
0, 5
0, 7 5
1
1, 2 5
1, 5
1, 7 5
2
2, 2 5
2, 5
2, 7 5
3
3, 2 5
3, 5
3, 7 5
-2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Pr o fi t m a r g i n s %
A
s
s
e
t
tu
r
n
o
v
e
r
A
D
E
G
F
H
I
B
C
Y
K
J
L
N
P
X
M
O
Analyzing Return on Assets--ROA
Relation Between Profit Margin and Asset Turnover
Profit Margin,Asset Turnover,and Return on Assets
for Selected Industries
P r o f i t M a r g i n,A s s e t T u r n o n v e r,a n d R e t u r n o n A s s e t s f o r S e l e c t e d
I n d u s t r i e s
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
P rof i t m a rgi n s %
A
s
s
e
t
t
u
rn
ov
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
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--ROA
Disaggregating Asset turnover
.,,
n
k)(1
)
1nt
BV(k
nt
NI
,,,
2
k)(1
)
1t
BV(k
2t
NI
k)(1
)
t
BV(k
1t
NI
t
BV
t
V ?
?
??
??
?
??
?
?
??
?
?
?
??
?
??
.,,
n
k)(1
1nt
k ) B V
nt
( R O C E
,,,
2
k)(1
1t
k ) B V
2t
( R O C E
k)(1
t
k ) B V
1t
( R O C E
t
BV
t
V ?
?
??
?
?
??
?
?
?
?
?
?
?
?
??
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
e q u i t y c o m m o n
A v e r a g e
a s s e ts
A v e r a g e
a s s e ts
A v e r a g e
S a l e s
S a l e s
d i v i d e n d s P r e fe r r e d
i n c o m e Ne t
e q u i t y c o m m o n
A v e r a g e
d i v i d e n d s P r e fe r r e d
i n c o m e Ne t
??
?
?
?
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
d i v i d e n d s P r e f e r r e d
e a r n i n g st a x -P r e
d i v i d e n d s P r e f e r r e d
i n c o m e N e t
S a l e s
d i v i d e n d s P r e f e r r e d
e a r n i n g st a x -P r e
S a l e s
d i v i d e n d s P r e f e r r e d
i n c o m e N e t
?
?
?
?
?
?
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
e q ui t y r s s t o c k ho l d e c o m m o n A v e r a g e p a y o u t D i v i d e n d d i v i de n d s P r e f e r r e d i n c o m e N e t = r a t e g r o w t h E q ui t y ??
? 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 growth
depends on both earnings
retention and return earned
on the earnings retained
r a t e ) P a y o u t(1 R O C E = r a t e g r o w t h e q u i t y eS u s t a i n a b l ??
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
Analyzing Return on Common Equity--ROCE
Analyzing Leverage on Common Equity
A n alyz i n g L ev erag e o n C o mm o n Eq u i ty ($ th o u sa n d s)
F ina ncing Sou rce Avera ge F un ds Ea rnin gs on F un ds Pa y m en t t o Acc ruin g t o (D etract ing
Su pp lied Su pp lied at 5.677 % F ina nciers f rom ) Re t urn on C om m on
Eq uity
C urr en t liab ilit ies $ 17 6,677 $ 10,03 0 $ 412
( a )
$ 9,618
Lo ng -term de bt 35 3,985 20,09 6 11,81 7
( b )
8,279
D eferre d t axes 93,96 2 5,334 none 5,334
Pr eferre d s t ock 41,53 8 2,358 2,908
( c )
(55 0 )
Ea rnin gs in ex c ess of return t o f ina nciers $ 22,68 1
Ad d,C om m on eq uity 68 6,640 38,98 0 — 38,98 0
T otals $ 1,352,80 2 $ 76,798 $ 15,13 7
T o tal retu rn to sh areh o l d ers $ 61,661
R eturn on ass ets 5.677 %
Le v era ge ad v an t ag e ac c ruin g t o c om m on eq uity 3.303
R eturn on c om m on eq uity 8, 98 0%
Analyzing Return on Common Equity--ROCE
Return on Shareholders’ Investment--ROSI
( c o s t ) p r i c e S h a r e
r e i n v e s t e d e a r n i n g s of v a l u e M a r k e t D i v i d e n d s ??R O S I
CHAPTER
Return on Invested
Capital
? Joint analysis is where one measure is
assessed relative to another
? Return on invested capital (ROI) is an important
joint analysis
Return on Invested Capital
Importance 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
?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 Capital
Application of ROI
(1)
evaluating
managerial
effective-
ness
(2)
assessing
profitability
(3)
earnings
forecasting
(4)
planning and
control
ROI is applicable to,
Return on Invested Capital
Evaluating 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
Return on Invested Capital
Measuring 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
Return on Invested Capital
Assists in Forecasting Earnings
? ROI links past,current,and forecasted earnings with
invested capital
? ROI adds discipline
to forecasting
? ROI helps identify
optimisticor pessimistic
forecasts
? ROI aids in evaluating prior forecast performance
Return on Invested Capital
For Planning and Control
ROI assists managers with,
? Planning
? Budgeting
? Coordinating activities
? Evaluating opportunities
? Control
Components of ROI
Definition
Return on invested capital is defined as,
c a p i t a l I n v e s t e d
I n c o m e
Components of ROI
Invested Capital Defined
? No universal measure
of invested capital
exists
? Different measures of
invested capital reflect
different financiers’
perspectives
Components of ROI
Alternative Measures of Invested Capital
Five Common Measures,
? Total Financing (Total Debt plus
Total Equity)
? Long-Term Debt Plus Equity
? Equity
? Market Value of Invested Capital
? Investor Invested Capital
Components of ROI
Total Debt and Equity Capital
? 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 ROI
Total Debt and Equity Capital
Some adjust this invested
capital base for,
1,Unproductive Assets
2,Intangible Assets
3,Accumulated Depreciation
Components of ROI
Total Debt and Equity Capital
Unproductive Asset Adjustment
? Assumes management not responsible for
earning a return on capital not in operations
? Excludes idle plant,facilities under
construction,surplus plant,surplus
inventories,surplus cash,and deferred
charges from invested capital
Adjustment is not valid as it fails to,
? recognize that management has discretion
over all investment
? assess overall management effectiveness
Components of ROI
Total Debt and Equity Capital
Intangible Asset Adjustment
? Assumes skepticism of intangible asset
values
? Excludes intangible assets from
invested capital
Adjustment is not valid as,
? Lack of information or increased
uncertainty does not justify exclusion
Components of ROI
Total Debt and Equity Capital
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
? Includes an addback for accumulated depreciation on
depreciable assets
Adjustment is not valid as,
? ROA analysis focuses on the performance
of the entire company
? 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 ROI
Long-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 long-term
capitalization
? Excludes current liability
financing
Components of ROI
Equity Capital
? Perspective is that of equity
holders
? Captures the effect of leverage
(debt) capital on equity holder
return
? 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)
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
Components of ROI
Computing 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 ROI
Income 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 debt plus equity 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 ROI
Adjustments 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
Components of ROI
Return on Assets (Debt and Equity) -- ROA
2 a s s e t s ) t o t a l E n d i n g a s s e t s t o t a l ( B e g i n n i n g
i n c o m e in i n t e r e s t M i n o r i t y r a t e )T a x (1 e x p e n s e I n t e r e s t i n c o m e N e t
??
???
Components of ROI
Return on Long-Term Debt plus Equity
e q u it y ) A v e r a g ed e b t t e r m-lo n g ( A v e r a g e
in c o m e inin t e r e s t M in o r i t yr a t e ) T a x(1 e x p e n s eIn t e r e s t in c o m eN e t
?
???
[Also called return on long-term capitalization]
Components of ROI
Return on Common Equity -- ROCE
Net income - Preferred dividends
Total common shareholders’ equity
[When ROCE is higher than ROA,it often reflects
favorable impacts of leverage]
ROCE is approximated by
Basic earnings per share
Book value per share
Analyzing Return on Assets--ROA
Disaggregating ROA
A s s e t s
S a l e s
S a l e s
I n c o m e
A s s e t s
I n c o m e ??
Profit margin,measures profitability relative to sale
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
R e l a ti o n b e tw e e n Pr o fi t M a r g i n,A s s e t T u r n o v e r,a n d
R e tu r n o n A s s e ts
0
0, 2 5
0, 5
0, 7 5
1
1, 2 5
1, 5
1, 7 5
2
2, 2 5
2, 5
2, 7 5
3
3, 2 5
3, 5
3, 7 5
-2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Pr o fi t m a r g i n s %
A
s
s
e
t
tu
r
n
o
v
e
r
A
D
E
G
F
H
I
B
C
Y
K
J
L
N
P
X
M
O
Analyzing Return on Assets--ROA
Relation Between Profit Margin and Asset Turnover
Profit Margin,Asset Turnover,and Return on Assets
for Selected Industries
P r o f i t M a r g i n,A s s e t T u r n o n v e r,a n d R e t u r n o n A s s e t s f o r S e l e c t e d
I n d u s t r i e s
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
P rof i t m a rgi n s %
A
s
s
e
t
t
u
rn
ov
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
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--ROA
Disaggregating Asset turnover
.,,
n
k)(1
)
1nt
BV(k
nt
NI
,,,
2
k)(1
)
1t
BV(k
2t
NI
k)(1
)
t
BV(k
1t
NI
t
BV
t
V ?
?
??
??
?
??
?
?
??
?
?
?
??
?
??
.,,
n
k)(1
1nt
k ) B V
nt
( R O C E
,,,
2
k)(1
1t
k ) B V
2t
( R O C E
k)(1
t
k ) B V
1t
( R O C E
t
BV
t
V ?
?
??
?
?
??
?
?
?
?
?
?
?
?
??
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
e q u i t y c o m m o n
A v e r a g e
a s s e ts
A v e r a g e
a s s e ts
A v e r a g e
S a l e s
S a l e s
d i v i d e n d s P r e fe r r e d
i n c o m e Ne t
e q u i t y c o m m o n
A v e r a g e
d i v i d e n d s P r e fe r r e d
i n c o m e Ne t
??
?
?
?
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
d i v i d e n d s P r e f e r r e d
e a r n i n g st a x -P r e
d i v i d e n d s P r e f e r r e d
i n c o m e N e t
S a l e s
d i v i d e n d s P r e f e r r e d
e a r n i n g st a x -P r e
S a l e s
d i v i d e n d s P r e f e r r e d
i n c o m e N e t
?
?
?
?
?
?
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
e q ui t y r s s t o c k ho l d e c o m m o n A v e r a g e p a y o u t D i v i d e n d d i v i de n d s P r e f e r r e d i n c o m e N e t = r a t e g r o w t h E q ui t y ??
? 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 growth
depends on both earnings
retention and return earned
on the earnings retained
r a t e ) P a y o u t(1 R O C E = r a t e g r o w t h e q u i t y eS u s t a i n a b l ??
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
Analyzing Return on Common Equity--ROCE
Analyzing Leverage on Common Equity
A n alyz i n g L ev erag e o n C o mm o n Eq u i ty ($ th o u sa n d s)
F ina ncing Sou rce Avera ge F un ds Ea rnin gs on F un ds Pa y m en t t o Acc ruin g t o (D etract ing
Su pp lied Su pp lied at 5.677 % F ina nciers f rom ) Re t urn on C om m on
Eq uity
C urr en t liab ilit ies $ 17 6,677 $ 10,03 0 $ 412
( a )
$ 9,618
Lo ng -term de bt 35 3,985 20,09 6 11,81 7
( b )
8,279
D eferre d t axes 93,96 2 5,334 none 5,334
Pr eferre d s t ock 41,53 8 2,358 2,908
( c )
(55 0 )
Ea rnin gs in ex c ess of return t o f ina nciers $ 22,68 1
Ad d,C om m on eq uity 68 6,640 38,98 0 — 38,98 0
T otals $ 1,352,80 2 $ 76,798 $ 15,13 7
T o tal retu rn to sh areh o l d ers $ 61,661
R eturn on ass ets 5.677 %
Le v era ge ad v an t ag e ac c ruin g t o c om m on eq uity 3.303
R eturn on c om m on eq uity 8, 98 0%
Analyzing Return on Common Equity--ROCE
Return on Shareholders’ Investment--ROSI
( c o s t ) p r i c e S h a r e
r e i n v e s t e d e a r n i n g s of v a l u e M a r k e t D i v i d e n d s ??R O S I
