Illustration 6: Adjusting Investment Returns for Cross Holdings - Tata Chemicals

Tata Chemicals is an Indian company that manufactures chemicals and fertilizers. It is part of the Tata Group, a holding company in multiple businesses including steel, hotels, food and technology. In its income statement for the 2006-2007 fiscal year. Tata Chemicals reported pre-tax operating income of Rs 5,855 million and a statutory tax rate of 33.66%. If we take the debt, equity and cash from the 2005-2006 balance sheet at face value, we arrive at the following estimate of pre-tax return on capital.

As part of the holding structure, there are significant intra-group holdings and Tata Chemicals has holdings in the other companies in the group. In its 2005-2006 balance sheet, Tata Chemicals reported a total book value of Rs. 4942.3 million for holdings in other companies, which it further broke up into an investment of Rs 1662.6 million in fully owned subsidiaries and Rs 3279.7 million in minority holdings in other Tata companies. Since the operating income from the former is consolidated into Tata Chemical's operating income, we will leave them as part of invested capital. The latter, though, should be removed from invested capital since the earnings from these investments are not part of the company's operating income:

This is the return on capital on Tata Chemicals, with its consolidated holdings. Since we are provided with information on the operating income from fully consolidated holdings (Rs 625 million in 2006-2007), we can also compute the return on capital of just the parent company:

Forecasting Future Returns

While much time and energy is spent estimating a firm's current returns on capital and equity, value is ultimately determined by expected returns on future investments.

Even if the current returns are computed correctly, there is no guarantee that these returns will continue into the future. In this section, we will consider several key questions on the predictability of investment returns, starting with how much information there is in past returns and industry averages and then moving on to consider the empirical evidence that exists on how quickly firms that make more than their cost of equity or capital see these excess returns fade. We close with a discussion of practical ways of estimating excess returns for the near future and the far future in valuation.

Historical Returns

When analyzing a firm, it is natural to begin with past history and to try to extrapolate these returns into the future. In this section, we look at three factors that should be considered when forecasting future returns. The first is the volatility in past returns; the return on capital and equity for a firm will change over time, more for some firms than others. The second is the effect of scale: As companies get larger, do returns on capital and equity start decreasing, and if so, how quickly? The third is the contrast between average and marginal returns, with the former measuring returns across all assets and the latter capturing the returns on just new investments taken during a period.

Volatility in Historical Returns

Few firms report stable returns on capital and equity over time, with both returns varying over time. Much of this volatility is caused by earnings variability, but some of it can be traced to changes in capital and equity invested over time. Generally speaking, we can state the following propositions about the volatility in investment returns:

a. Return volatility increases with the level of returns: In keeping with the adage that high return and high risk go hand in hand, return volatility increases with the level of returns. In other words, there is likely to be higher volatility in a firm with a 15% return on capital than in a firm with a 7% return on capital.

b. Return volatility is higher for younger, high growth firms than it is for more mature firms: Returns are more unpredictable and unstable early in a firm's life cycle, when the firm is trying to find a place for its products and the competition is evolving. As firms mature, returns become more stable.

c. The returns on equity are more volatile than the returns on capital: Equity earnings will be more volatile than operating earnings, largely because interest expenses comprise a fixed cost. Consequently, equity earnings tend to go up more than operating earnings in good time and go down more in bad times. The effect of this increased equity earnings volatility on the return on equity is magnified by the fact the denominator - equity capital - can be a small slice of the overall capital.

d. Investment return volatility is correlated with stock return volatility: While returns on equity and capital are based upon accounting earnings and capital, and are designed to measure the quality of a firm's existing investments, they are correlated with returns you would make investing in the publicly traded equity of the firm. Firms with volatile returns on equity tend to have volatile stock prices, which translate into volatile returns.

So, how much can we trust historical returns when making forecasts of future returns? Notwithstanding the evidence that returns are volatile over time, the evidence suggests that there is a surprising degree of persistence in historical returns at firms. Put another way, firms that have earned high returns in the past are likely to keep earning high returns at least in the near future. However, the confidence with which we can make this statement will be greater for firms that have reported stable returns in the past than for firms with volatile returns.

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