ROIC & PROFITABILITY ANALYSIS

Return on Invested Capital

Importance of Joint Analysis

•• Joint
Joint analysis
analysis isis where
where one
one measure
measure isis
assessed
assessed relative
relative to
to another
another

•• Return
Return onon invested
invested capital
capital (ROIC)
(ROIC) or
or
Return
Return on on Investment
Investment (ROI)
(ROI) isis an
an
important
important joint
joint analysis
analysis
 Return on Invested Capital
••ROI
ROI allows
allows us
us to
to compare
compare companies
companies on
on their
their success
success
with
with invested
invested capital,
capital, assess
assess aa company’s
company’s return
return relative
relative
to
to its
its capital
capital investment
investment risk,
risk, and
and compare
compare the
the return
return on
on
invested
invested capital
capital to
to returns
returns of
of alternative
alternativeinvestments.
investments.
••ROI
ROI compares
compares aa company’s
company’s income,
income, or
or other
other performance
performance
measure,
measure, to
to aa company’s
company’s level
level and
and source
sourceof
of financing
financing
••ROI
ROI determines
determines aa company’s
company’s ability
ability to
to succeed,
succeed, attract
attract
financing,
financing, repay
repay creditors
creditors and
and reward
reward owners
owners
 Components of ROI
Return on invested capital is defined as:

Income
Invested Capital
 Components of ROI
Invested Capital Defined

• No universal measure from which to compute rate

of return
• Different measures of invested capital reflect users’
different perspectives
Common Measures:
• Net Operating Assets
• Stockholders’ Equity
 Net Operating Assets (NOA)
•• Operating
Operating activities
activities are
are the
the most
most long-
long-
lasting
lasting and
and relevant
relevant for
for the
the determination
determination ofof
stock
stock price.
price.
••Operating
Operating activities
activities are
are the
the core
core activities
activities of
of
the
the company
company
What
What items
items inin the
the income
income statement
statement areare
reflected
reflected as
as operating
operating activities?
activities?

How
How about
about the
the balance
balance sheet?
sheet?
 Net Operating Assets (NOA)
NOA
NOA
••Operating
Operating assets
assets are
are comprised
comprised of of total
total
assets
assets less
less financial
financial assets.
assets.
•Operating
•Operating liabilities
liabilities are
are comprised
comprised of of
total
total liabilities
liabilities less
less interest-bearing
interest-bearing
debt.
debt.
•Operating
•Operating assets assets lessless operating
operating
liabilities
liabilities yields
yields net
net operating
operating assets
assets
(NOA).
(NOA).
 Components of ROI
Net Operating Profit after Tax
(NOPAT)

Net
Net operating
operating Profit
Profit after
after tax
tax (NOPAT)
(NOPAT)
equals
equals revenue
revenue less
less operating
operating expenses
expenses
such
such asas cost
cost of
of goods
goods sold,
sold, SG&A
SG&A
expenses,
expenses, and
and taxes.
taxes.
 Components of ROI
Common Equity Capital
•• Our
Our analytical
analytical perspective
perspective is is that
that ofof
common
common equity
equity holders.
holders.
•• Common
Common equity equity isis equal equal to to total
total
shareholders’
shareholders’equity
equity less
less preferred
preferred stock.
stock.
•• Common
Common equityequity can can alternatively
alternatively be be
defined
defined as
as equal
equal to
to total
total assets
assets less
less debt
debt and
and
preferred
preferred stock
stock
•• The
The amount
amount of of equity
equity isis aa function
function ofof the
the
degree
degree to
to which
which thethe company
company is is financed
financed
with
with debt
debt ..
 Components of ROI
Net income
•• NetNet income
income isis impacted
impacted by
by the
the amount
amount ofof
interest
interest expense
expense that
that the
the company
company must
must pay
pay
on
on its
its debts.
debts.
•• TheThe return
return on
on common
common equity
equity captures
captures
both
both thethe returns
returns onon net
net operating
operating assets
assets
(RNOA)
(RNOA) discussed
discussed above
above and
and the
the effects
effects of
of
financial
financial leverage.
leverage.
Computing Invested Capital

•Usually computed using

average capital available to the
company for the period.
•Add beginning and ending
year invested capital and
divide by 2
•Or average interim amounts
— quarterly or monthly
Return on Net Operating Assets -- RNOA

NOPAT
NOPAT
(Beginning
(Beginning NOA
NOA ++ Ending
Ending NOA)
NOA) // 22

Where
• NOPAT = Operating income x (1- tax rate)
• NOA = net operating assets
Return on Net Operating Assets -- RNOA

•• Operating
Operating assets
assets include
include cash,
cash, accounts
accounts
receivable,
receivable, inventories,
inventories, prepaid
prepaid
expenses,
expenses, deferred
deferred tax tax assets,
assets, property,
property,
plant
plant and
and equipment
equipment (PPE),(PPE), and
and long
long
term
term investments
investments related
related to
to strategic
strategic
acquisitions
acquisitions
•• Operating
Operating liabilities
liabilities include
include accounts
accounts
payable,
payable, accrued
accrued expenses,
expenses, deferred
deferred
income
income tax
tax liabilities…
liabilities…
Return on Net Operating Assets -- RNOA

•• Non-operating
Non-operating assets
assets include
include
investments
investments in in marketable
marketable securities,
securities,
nonstrategic
nonstrategic equity
equity investments,
investments, and and
investments
investments in in discontinued
discontinued operations
operations
prior
prior to
to sale
sale
•• Non-operating
Non-operating liabilities
liabilities include
include bonds
bonds
and
and other
other long-term
long-term interest-bearing
interest-bearing
liabilities,
liabilities, and
and the
the noncurrent
noncurrent portion
portion of
of
capitalized
capitalized leases,
leases, dividends
dividends payable.
payable.
Return on Net Operating Assets -- RNOA
Net Operating Profit after Tax (NOPAT)
Return on Common Equity -- ROCE

Net
Net income
income -- Preferred
Preferred dividends
dividends
(Beginning
(Beginning equity
equity ++ Ending
Ending equity)
equity) // 22

Where
• Equity is stockholder’s equity less preferred stock
 Disaggregating RNOA
Return on operating assets =
Operating Profit margin x Operating Asset turnover

NOPAT NOPAT Sales

 
Avg. NOA Sales Avg. NOA
Operating Profit margin (NOPAT margin): measures a
company’s operating profitability relative to sales
Operating Asset turnover (NOA turnover): measures a
company’s effectiveness in generating sales from net
operating assets
Effect of Operating Leverage on RNOA

OA = operating assets
OLLEV = operating liabilities leverage ratio
(avg. operating liabilities / avg. NOA)
Relation between Profit Margin and Asset
Turnover
Relation between Profit Margin and Asset
Turnover
• Profit margin and asset turnover are
interdependent
– Profit margin is a function of sales and
operating expenses.
Sales equals selling price multiplied by units sold.
– Turnover is also a function of sales
(sales/assets)
Relation between Profit Margin and Asset
Turnover
Relation between Profit Margin and Asset
Turnover
Disaggregating RNOA
Disaggregating Profit Margin
 Gross Profit Analysis
Gross Profit
– Revenues less cost of sales – frequently reported as a
percent (gross profit percent) – computed as gross profit
divided by sales
– Gross profit covers all costs, finance essential future-
directed discretionary expenditures
– Gross profits vary across industries
– Major drivers of gross profit
+Increase (decrease) in sales volume
+Increase (decrease) in per-unit selling price
+Increase (decrease) in cost per unit
 Gross Profit Analysis
Gross Profit
– Strategic activities to remedy or improve gross
profit
+ The reason for a decrease in gross profit is a
decline in unit selling prices
+ The reason for a decrease in gross profit is an
increase in unit costs
– Direct attention to potential distortions arising
from accounting methods (Especially inventories
and depreciation accounting)
 Gross Profit Analysis
• Selling Expenses
– Distinguish variable and fixed components
– When selling expenses as a percentage of
revenues show an increase, we should focus
attention on the increase in generating the
associated increase in revenues
– Sales promotion expenses - year-to-year
trends
• General and Administrative Expenses
Fixed; Direct attention at both the trend in these
expenses and the percentage of revenues they
consume
 Disaggregation of Asset Turnover
Sales
average net operating assets
• Asset turnover measures the intensity with which
companies utilize assets
• The most relevant measure of asset utilization is sales
• Further evaluation of components changes in turnover
rates for individual assets can be useful in a company
analysis
Caution:
• Increase in turnover rates by lowering our
investment in assets might be
counterproductive
• Our investment in assets must be optimized,
not necessarily minimized.
 Disaggregation of Asset Turnover
• Accounts Receivable turnover
• Average collection period
• Inventories turnover
• Average inventory days outstanding
• Accounts Payable turnover
• Average payable days outstanding
• Long-term Operating Asset turnover
• Net operating working capital turnover
 Disaggregation of Asset Turnover

• The relative productivity of long-term operating assets, on

average
• Differ across industries
• The ways of Increasing in long-term operating asset turnover

• Net operating working capital is equal to operating current

assets less operating current liabilities
• The higher net working capital turnover, the better
Return on Common Equity Analysis

Net
Net income
income -- Preferred
Preferred dividends
dividends
(Beginning
(Beginning equity
equity ++ Ending
Ending equity)
equity) // 22

Where
Equity is stockholder’s equity less preferred stock
Disaggregating ROCE
Alternate View of ROCE Disaggregation
 Disaggregation of ROCE
• The vast majority of companies
provide goods and services to
customers as their primary business
• Operating activities have the most
pronounced and long-lasting effects
on company value
• Increasing debt increases the risk of
default
 Additional analysis
• The degree of financial leverage is generally
under control of the company
• Spread is a function of the interest rate on
debt and investment returns

• The resulting increase from an increased

spread in ROCE should not be given as much
weight in our analysis as will an increase
resulting from more persistent operating
returns.
Analyzing Return on Common Equity-ROCE

Assessing Equity Growth

Net income  Preferred dividends  Dividend payout

Equity growth rate =
Average common stockholde rs’ equity

•• Assess
Assess common
common equity
equity growth
growth
rate
rate through
through earnings
earnings
retention
retention
•• Assume
Assume earnings
earnings retention
retention and
and aa
constant
constantdividend
dividend payout
payout
Analyzing Return on Common Equity-ROCE

Assessing Equity Growth

Sustainabl e equity growth rate = ROCE  (1Payout rate)

Assumes
Assumesinternal
internalgrowth
growthdepends
dependsonon
both
bothearnings
earningsretention
retentionand
andreturn
return
earned
earnedon
onthe
theearnings
earningsretained
retained