Adjusting Capital for Extraordinary items

Consider a firm that invests $ 10 billion in an asset that generates only a half a billion in after-tax operating income on a continuing basis. The computed return on capital for this asset is 5%, reflecting its mediocrity as an investment. However, let us assume that this firm decides to write off half the investment, reducing capital invested to $ 5 billion. The return on capital, using the updated invested capital number, is now 10% but the quality of the investment has not changed.

In practice, there are a number of ways in which firms can reduce their reported capital. They can take restructuring charges and report one-time expenses or report that their assets have "impaired value". With the trends towards "fair value" accounting, they can even mark assets to the market and reduce their reported value. While there are accounting rules that govern each of these transactions, there is enough leeway within these rules to allow aggressive firms to decrease the "invested capital" base and increase the returns on equity and capital.

To counter this, we should be adjusting the reported capital base for actions taken by the firm to reduce that base. Making this adjustment, though, is much more difficult to do than adjusting earnings, since the effect on capital is a cumulated effect: all restructuring charges, taken over time, by the firm, affect the current capital invested. Thus, we have to start with capital invested currently and add back charges made over time to this capital. The older the firm, the more complicated this process will undoubtedly become.

Dividends and Stock Buybacks

When a firm pays dividends or buys back stock, it reduces its book value of equity by the amount of the dividend or stock buyback, and can affect its net income, to the extent that the cash used to pay the dividend or buy back stock generated income in prior periods. Consequently, dividends and stock buybacks can affect the returns on equity of the firms involved. In general, the return on equity of a firm that pays a large dividend or buys back stock will increase after the transaction because the book value of equity will decrease disproportionately, relative to the net income. Consider, for instance, a firm that reports net income of $ 10 million on book value of equity of $ 100 million.

Assume that the firm has a $ 20 million cash balance on which it earns after-tax interest income of $ 1 million. Using this cash to buy back stock or pay a dividend will reduce net income by $ 1 million and book value of equity by $ 20 million, resulting in a return on equity of 11.25%:

The effect on return on invested capital and non-cash return on equity will be muted or non-existent because those returns are computed only on the invested capital n operating assets. Thus, using cash to buy back stock has no effect on either after-tax operating income or invested capital. The same can be said about borrowing the money needed to fund the dividends/buyback.

In practice, the effects that dividends and buybacks have on returns on equity can be viewed as an argument for using return on invested capital or non-cash return on equity to judge firms that frequently buy back stock or pay large dividends. However, in the long term, even the return on capital and non-cash return on equity can be affected by stock buybacks, especially at firms where the market value of equity is significantly higher than the book value of equity.

See Technical Indicators