www.futurumcorfinan.com

Page 1

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

Sukarnen

DILARANG MENG-COPY, MENYALIN,

ATAU MENDISTRIBUSIKAN

SEBAGIAN ATAU SELURUH TULISAN

INI TANPA PERSETUJUAN TERTULIS

DARI PENULIS

Untuk pertanyaan atau komentar bisa

diposting melalui website

www.futurumcorfinan.com

www.futurumcorfinan.com

Page 2

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.

~~~~~~ ####### ~~~~~~

www.futurumcorfinan.com

Page 3

Disclaimer

This material was produced by and the opinions expressed are those of FUTURUM as of the date of

writing and are subject to change. The information and analysis contained in this publication have

been compiled or arrived at from sources believed to be reliable but FUTURUM does not make any

representation as to their accuracy or completeness and does not accept liability for any loss arising

from the use hereof. This material has been prepared for general informational purposes only and is

not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your

advisors for specific advice.

This document may not be reproduced either in whole, or in part, without the written permission of

the authors and FUTURUM. For any questions or comments, please post it at

www.futurumcorfinan.com

© FUTURUM. All Rights Reserved