Measuring Investment Returns

Now that we have established how critical it is that we get a reasonable estimate of the return earned on existing investments, we need to consider the alternatives. In this section, we will first explore the two measures of return based on accounting earnings - return on capital and return on equity - that are widely used in practice and then turn our attention to cash based returns and why they have not attracted as wide a following in practice.

Accounting Returns

Given that much of the information that we work with in valuation and corporate finance comes from accounting statements, it should come as no surprise that the most widely used measures of return are based upon accounting earnings. In keeping with our earlier differentiation between returns to all capital and just to equity investors, accounting returns can be categorized accordingly.

a. Return on Invested Capital

The return on capital or invested capital in a business attempts to measure the return earned on capital invested in an investment. In practice, it is usually defined as follows:

There are four key components to this definition. The first is the use of operating income rather than net income in the numerator. The second is the tax adjustment to this operating income, computed as a hypothetical tax based on an effective or marginal tax rate. The third is the use of book values for invested capital, rather than market values. The final is the timing difference; the capital invested is from the end of the prior year whereas the operating income is the current year's number. There are good reasons for each of these practices and we will examine the details in the sub-sections that follow.

I. After-tax Operating Income

The return on capital measures return generated on all capital, debt as well as equity, invested in an asset or assets. Consequently, it has to consider earnings not just to equity investors (which is net income) but also to lenders in the form of interest payments. Thus, operating income, as a pre-debt measure of earnings, is used in the computation, and it is adjusted for taxes to arrive at an after-tax return on capital. There are two ways of estimating this operating income.

One is to use the reported earnings before interest and taxes (EBIT) on the income statement and to adjust this number for the tax liability.

Note that when we use this computation, we are in effect acting as if we pay taxes on that measure of income. In reality, we get to subtract interest expenses to get to taxable income but we ignore this tax benefit since it is already incorporated into the cost of capital (through the use of an after-tax cost of debt). A common error made in the computation of return on capital is using actual taxes paid in the computation of the after-tax operating income. This will result in a double counting of the tax benefit from debt, once in the return on capital (which will be increased because of the interest tax savings) and again in the cost of capital (which will be reduced the reflect the same tax benefit).2

The other is to start with net income and to add back after-tax interest expenses and eliminate other non-operating items to arrive at the after-tax operating income:3

In this computation, no explicit tax adjustment is made, since we start with net income, which is already after taxes. Adding back the after-tax portion of interest expenses ensures that the tax benefit from debt does not get double counted.4

2 This is best illustrated using a simple example. Assume that a firm has $100 million in earnings before interest and taxes, $60 million in interest expenses and faces a tax rate of 40%. The taxable income for the firm is $40 million (EBIT - Interest Expenses) and the taxes paid will be $16 million. The after-tax operating income that should be used for the return on capital should be $ 60 million ($100 million (1-.4)) and not $ 84 million ($100 million - $16 million).

3 This adjusted version of after-tax operating income is sometimes referred to as NOPLAT (Net operating profit (loss) after taxes).

4. The equivalence of the two approaches can be shown with the example used in the last footnote. The firm with $ 100 million in operating income, $60 million in interest expenses and a 40% tax rate will report net income of $ 24 million. Adding back the after-tax interest expense of $ 36 million ($ 60 million (1-.4)) will yield an after-tax operating income of $ 60 million.

See Technical Indicators