Investment Returns: What and Why?

In finance and accounting, there are frequent references to returns on investments and different definitions of these returns. To better understand, what we are trying to measure with investment returns, consider a financial balance sheet in figure 1.

Figure 1: A Financial Balance Sheet

Note the contrast to an accounting balance sheet, which is more focused on categorizing assets based upon whether they are fixed, current or intangible and recording them at accounting or book value estimates of value. Note also the categorization of assets in this balance sheet into assets in place and growth assets, thus setting up the two basic questions to which we need answered in both corporate finance and valuation:

a. How good are the firm's existing investments? In other words, do they generate returns that exceed the cost of funding them?
b. What do we expect the excess returns to look like on future investments?

The answer to the first question lies in the past and will require us to focus on the capital that the firm has invested in assets in place and the earnings/cash flows it generates on these investments. In effect, this is what we are trying to do when we compute the return on invested capital and compare it to the cost of capital. To answer the second question, we may very well start with past returns but we cannot stop there. After all, the competitive environment and investment potential for the firm may have changed substantially and these changes have to be incorporated into the forecasts of future returns. In practical terms, this will require us to adjust past returns for changes or even replace them with new and different measures of return for future investments. The categorization of capital into equity and debt also provides us with a simple way of differentiating between different ways of measuring returns. We can focus on just the equity invested in projects and measure the return on this equity investment; this would then have to be compared to the cost of equity. Alternatively, we can measure the overall return earned on call capital (debt and equity) invested in an investment; this is the return on capital and can be compared to the cost of capital.

See Technical Indicators