Corporate finance and valuation are filled with ratios and measures that are often not only obscure to outsiders but defined in many different and contradictory ways by practitioners and academics. The table below is my attempt to provide some underlying rationale for wh the measure is used in the first place, the best way to define each measure and some comments on their use or misuse. Difference between the actual returns earned on a traded investment stock, bond, real asset and the return you would have expected to make on that investment, given its risk. Returns from both price appreciation and dividends or cash flow generated by an investment during a year. It is usually measured using a regression of stock returns against returns on a market index; the slope of the line is the beta.
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Post a Comment. If asked to describe a successful business, most people will tell you that it is one that makes money and that is not an unreasonable starting point, but it is not a good ending point. For a business to be a success, it is not just enough that it makes money but that it makes enough money to compensate the owners for the capital that they have invested in it, the risk that they are exposed to and the time that they have to wait to get their money back.
That, in a nutshell, is how we define investment success in corporate finance and in this post, I would like to use that perspective to measure whether publicly traded companies are successful. Measuring Investment Returns. The first step towards measuring investment success is measuring the return that companies make on their investments.
This step, though seemingly simple, is fraught with difficulties. First, corporate measures of profits are not only historical as opposed to future expectations but are also skewed by accounting discretion and practice and year-to-year volatility. Second, to measure the capital that a company has invested in its existing investments, you often have begin with what is shown as capital invested in a balance sheet, implicitly assuming that book value is a good proxy for capital invested.
Notwithstanding these concerns, analysts often compute a return on invested capital ROIC as a measure of investment return earned by a company:. In the context of reporting this statistic at the start of last year, I reported my ROIC caveats in a picture:. I compute the return on invested capital at the start of for each company in my public company sample of 42, firms, using the following judgments in my estimation:.
That said, I have the law of large numbers as my ally. If the measure of investment success is that you are earning more on your capital invested than you could have made elsewhere, in an investment of equivalent risk, you can see why the cost of capital becomes the other half of the excess return equation. The cost of capital is measure of what investors can generate in the market on investments of equivalent risk. Thus, a company that can consistently generate returns on its invested capital that exceed its cost of capital is creating value, one that generates returns equal to the cost of capital is running in place and one that generates returns that are less than the cost of capital, it is destroying value.
Of course, this comparison can be done entirely on an equity basis, using the cost of equity as the required rate and the return on equity as a measure of return:. In general, especially when comparing large numbers of stocks across many sectors, the capital comparison is a more reliable one than the equity comparison. My end results for the capital comparison are summarized in the picture below, where I break my global companies into three broad groups. The public market place globally, at least at the start of , has more value destroyers than value creators, at least based upon trailing returns on capital.
If you are wary because the returns computed used the most recent 12 months of data, you are right be. To counter that, I also computed a ten-year average ROIC for those companies with ten years of historical data or more and that number compared to the cost of capital.
Finally, if you are doing this for an individual company, you can use much more finesse in your computation and use this spreadsheet to make your own adjustments to the number.
Regional and Sector Differences If you accept my numbers, a third of all companies are destroying value, a third are running in place and a third are creating value, but are there differences across countries? I answer that question by computing the excess returns, by country, in the picture below:. Many of the sectors that delivered the worst returns in were in the natural resource sectors, and depressed commodity prices can be fingered as the culprit.
For investors, looking at this listing of good and bad businesses in , I would offer a warning about extrapolating to investing choices. The correlation between business quality and investment returns is tenuous, at best, and here is why. To the extent that the market is pricing in investment quality into stock prices, there is a very real possibility that the companies in the worst businesses may offer the best investment opportunities, if markets have over reacted to investment performance, and the companies in the best businesses may be the ones to avoid, if the market has pushed up prices too much.
There is, however, a corporate governance lesson worth heeding. Notwithstanding claims to the contrary, there are many companies where managers left to their own devices, will find ways to spend investor money badly and need to be held to account.
I am not surprised, as some might be, by the numbers above. A large number of companies, if put on the spot, will not even able to tell you how much capital they have invested in existing assets, either because the investments occurred way in the past or because of the way they are accounted for. It is not only investors who bear the cost of these poor investments but the economy overall, since more capital invested in bad businesses means less capital available for new and perhaps much better businesses, something to think about the next time you read a rant against stock buybacks or dividends.
Posted by Aswath Damodaran at PM. Labels: Data Update , Excess Returns. Newer Post Older Post Home. Subscribe to: Post Comments Atom. Link to live map. Spreadsheet with country data. Spreadsheet with sector data.
The Hottest Metric in Finance: ROIC
The list of metrics I look at when I analyze businesses is long: revenue growth, operating margins, free cash flow, payout ratios, etc. But if I could look at only one metric about a business to judge the quality of that business- ROIC would be the metric. Good businesses generate high returns on capital and they do so with consistency. Return on capital is important because it is a fundamental driver of valuation. Businesses that can generate higher returns on capital can invest less in capital expenditures and thus generate more free cash flow to distribute to shareholders.
ROIC = NOPAT / Invested Capital
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