II. Invested Capital

In most financial computations, when given a choice between market value and book value, we choose to proceed with market value. Thus, the cost of capital is computed using market value weights for debt and equity and betas are levered and unlevered using market values. The accounting return computation is perhaps the only place in finance where we revert back to book value, and the reason we do it is simple. We are trying to compute the return earned on the capital invested in existing assets and we are assuming that the book values of debt and equity effectively measures this capital investment. The market value of equity has two problems that make it inappropriate for this computation:

(1) The market value of equity includes the expected value of growth assets, which cannot generate operating income today. Consequently, the return on capital computed using market values of debt and equity for a growth firm will be biased downwards, not because the firm has taken poor investments but because its market value incorporates expectations for the future. Consider, for instance, that the market value of Google in 2007 was approximately $ 150 billion, much of which was due to growth potential. Dividing Google's operating income of $ 3 billion in that year by the market value would generate a return on capital of 2%, but that would not be a fair measure of the quality of Google's investments. Dividing instead by Google's book value of $15 billion yields the more reasonable estimate of return of 20% on its existing investments.

(2) The market value marks up the value of existing assets to reflect their earning power. In other words, even if there were no growth assets, using the market value of existing investments in this computation will generate the unsurprising result that the return on capital is equal to the cost of capital. Consider a firm that has only one project and no expected future investments, and assume that the capital invested in the project was $50 million and that the project is expected to generate $10 million in annual earnings / cash flow in perpetuity. Finally, assume that the cost of capital for this project is 10% and that the market values it fairly, giving it a value of $100 million (the present value of $10 million as a perpetuity, discounted back at 10%). Now, consider the options when it comes to computing return on capital. If you divide the earnings by the book value of $50 million, you arrive at a return on capital of 20% and the fair conclusion that the firm is generating excess returns on its only investment. If you divide the earnings by the market value of $100 million, the return on capital is 10% and the conclusion that you would draw is that the firm invested in a neutral project, which is not a fair assessment.5

The reason we net out cash is to be consistent with the use of operating income as our measure of earnings. The interest income from cash is not part of operating income. Consequently, dividing the operating income by the total book value of debt and equity will yield too low a return on capital for companies with significant cash balances. We could, of course, add back interest income from cash to the numerator but that would muddy the waters since cash is generally invested in low-risk, low-return investments.

While the computation that we have used begins with the book values of debt and equity, we could arrive at a similar result using the book values of the assets of the firm. In fact, the equivalence of the balance sheet can be used to arrive at the following measure of invested capital:

The two approaches will generally give you equivalent results with two exceptions. The first is when the firm has minority holdings in other companies that are classified as assets on a balance sheet. Since these assets are not viewed as operating assets, they will be excluded from the invested capital computation when we use the asset-based approach but will be implicitly included in it when we use the capital computation. The second is when the firm has long-term liabilities that are not categorized as debt - unfunded pension or health care obligations, for instance. They will be excluded from the invested capital computation when we use the capital approach since we consider only equity and interest bearing debt but will be included in the computation when we use the asset approach.

 

5 If the market is not efficient, this computation will become even noisier, pushing down the return on capital if the market is overvaluing the firm and pushing it up, if the firm is under valued.

See Technical Indicators