Conclusion
The
return on investment, whether measured to
just equity investors or to all capital is
a key input in both corporate finance and
valuation. Consequently, there is a payoff
to measuring it correctly in the first place.
We began this paper by looking at why we attach
so much weight to the returns and capital
and equity, and how the excess returns we
compute underlie the values we attach to companies.
While the accounting measures of these returns
relate accounting earnings to book value,
they can be biased by accounting misclassification
of expenses - treating R&D and operating leases
as operating expenses skews operating income
and capital - and accounting choices - depreciation
and restructuring charges can lower book value
and increase reported returns. We considered
ways in which we can derive more reliable
and cleaner measures of these returns.
Having
measured returns on investments from the past,
we faced the tougher task of forecasting these
returns for future periods. We considered
how best to weight the past return history
of a firm, sector averages and the costs of
equity and capital to make this judgment.
Ultimately, positive excess returns - return
in excess of costs - have to come from competitive
advantages or barriers to entry into sectors.
Stronger and more sustainable competitive
advantages should lead to larger excess returns
over longer period. Thus, firms that have
generated high returns in the past may continue
to make these returns for the next few years,
but the excess returns will start decreasing
as firms become larger and competition increases.
Return to document index
