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THE ALTERNATIVES
Return on Equity [ROE]
Earnings [cash flows] divided by shareholders equity [Balance sheet assets minus liabilities]
RETURN ON EQUITY
(Income)
Profit Margin
(Assets)
Turnover
(Liabilities)
Leverage Debt-toWhatever Times Interest Earned
By looking at trends in return on equity and analyzing the components, the investor is forced to not only examine the Statement of Operations, or the Income Statement, but also to balance this against the left and right sides of the Balance Sheet.
An Example
Calculated using book values and tax depreciation rates, the accounting rate of return is: Rac(t) = Accounting Income (t)/ Accounting Book Value (t)
BUT Rac is the true ROI (R), if and only if and tax depreciation rates = the true rate of depreciation (D) are equal. For example, if R = .05 and D = .15, if the depreciation rate used is .2, even though the true R is constant and equals .05, the measured Rac is -.06 in Year 1 and .08 in Year 2 (.91 in year 20) (assume I =100 in t-1, so real income = 4.5 in year 1 and 3.6 in year 2).
An Example (a)
Assume that you have a firm with
IA = 100 In each year 1-5, assume that ROCA = 15% D I = 10 (Investments at beginning of each year) WACCA = 10% ROC(New Projects) = 15% WACC = 10%
Assume that all of these projects will have infinite lives. After year 5, assume that
* Investments will grow at 5% a year forever * ROC on projects will be equal to the cost of capital (10%)
An Example (b)
Capital Invested in Assets in Place = $ 100
EVA from Assets in Place = (.15 - .10) (100)/.10 = $ 50 + PV of EVA from New Investments in Year 1 = [(.15 - .10)(10)/.10] = $ 5 + PV of EVA from New Investments in Year 2 = [(.15 - .10)(10)/.10]/1.12 = $ 4.55 + PV of EVA from New Investments in Year 3 = [(.15 - .10)(10)/.10]/1.13 = $ 4.13 + PV of EVA from New Investments in Year 4 = [(.15 - .10)(10)/.10]/1.14 = $ 3.76 + PV of EVA from New Investments in Year 5 = [(.15 - .10)(10)/.10]/1.15 = $ 3.42 Value of Firm = $ 170.86
This formula for the asset price applies not just at time 0, but at any time y. Hence:
K(y) p(y) = xy R(t) K(t) e-r(t-y) dt, By taking the derivative of this equation with respect to y, one obtains: K(y) p(y) + K(y) p(y) = r(y) K(y) + r xy R(t) K(t) e-r(t-y) dt
Hence:
R(y) = (r + d - [p/p]) p(y).
This means that that the rental rate per asset equals interest foregone, plus depreciation, minus any price appreciation or decline.
Returns
How do you measure return on capital? * Again, the accounting definition of return on capital may not reflect the economic return on capital. * In particular, the operating income has to be cleansed of any expenses which are really capital expenses (in the sense that they create future value). One example would be R& D. * The operating income also has to be cleansed of any cosmetic or temporary effects. How do you estimate cost of capital? * DCF valuation assumes that cost of capital is calculated using market values of debt and equity. * If it assumed that both assets in place and future growth are financed using the market value mix, the EVA should also be calculated using the market value. * If instead, the entire debt is assumed to be carried by assets in place, the book value debt ratio will be used to calculate cost of capital. Implicit then is the assumption that as the firm grows, its debt ratio will approach its book value debt ratio.