The
Scale Effect
It
stands to reason that the return on capital,
as a percentage measure, should be higher
for smaller firms and lower for larger firms.
When we categorize firms based upon size,
using different definitions for size including
revenues and market capitalization, there
is some correlation between the size of a
company and its reported returns. In figure
7, for instance, we report average returns
on capital for firms of different size, using
invested capital as the measure of size.26
The
firms with the smallest and largest amounts
of invested capital have the lowest returns,
the former because they include a large number
of early life-cycle firms that are losing
money and the latter because of mature firms.
If
we track individual firms as they get larger,
there is a strong evidence of a scale effect,
as the returns on capital decrease as firms
get larger. However, the effect is muted by
the fact that we are looking at the aggregate
return on capital for the firm rather the
marginal return on capital, a point we expand
upon in the next section. As to the relevance
for return forecasting, this would suggest
that forecasted returns on capital and equity
should decrease as we go further out in forecast
periods, as firms get larger over time. Thus,
while a 30% return on capital can be legitimate
for the first year of a forecast, the return
should be lower five years forward.
Average
versus Marginal
The
returns that we are computing using the total
earnings for the firm and the total capital
invested represent average returns across
all of the investments that the firm has taken
over time. But how good or bad were the investments
made just in the most recent time period?
. That question is better answered by focusing
on the marginal return - the return on just
the new investments made in a period. If we
begin with the proposition that firms invest
in their best projects first and move down
their investment schedule to less and less
attractive investments, the marginal return
on capital (or equity) should be lower than
the average return for most firms.
But
how do we go about measuring the marginal
return? In a perfect world, we would have
access to the earnings and cash flow estimates
on individual projects, and compute the internal
rates of returns on the projects accepted
during the period in question. In practice,
we not only do not have access to this information,
but even if we did, the estimates are likely
to be biased.27
One measure, albeit an imperfect one, is based
upon the change in earnings and capital invested
during the period:
Assume
that a firm reports $ 50 million in after-tax
operating income on invested capital of $400
million has a return on capital of 12.5%.
Now assume that the firm reports aftertax
operating income of $ 54 million on invested
capital of $500 million the following year.
The return on capital for this firm is 10.8%,
a healthy number that disguises the poor marginal
return on capital that year:
The
average returns on capital will be more stable
and persistent than the marginal returns on
capital, and the difference between the two
numbers will widen as the company becomes
larger. In fact, it can take several years
of sub-standard marginal returns for the average
return on capital on a large company to decline
sufficiently to warrant attention.
26
We used invested capital as our measure of
size, rather than market capitalizations because
companies that earn high returns on capital
will tend to have high market capitalizations.
27
There is evidence that cash flow projections
in capital budgeting tend to be optimistic
(and biased upwards). Using these cashflows
will generate rates of return that are higher
than the true expected returns.
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