III. Timing Differences

Assume that you buy a stock for $50 at the start of a period and that it rises to $70 over the period. If you were computing the return you earned on this stock, you would compute it to be 40% (obtained by dividing the change in price by the price at the start of the period). It is the same reasoning that drives us to use the capital invested at the start of the period in computing return on invested capital. Using the rationale that investments made during the course of a year will generally not start generating earnings during the year, we divide the operating income for the year by the capital invested at the beginning of the year. It should be noted that there are some analysts who prefer to use the average of the capital invested during the year, obtained by averaging the capital invested at the beginning and end of the year, as the base.6

Final Thoughts

Note that if the return on capital works as advertised, it should give us a measure of the return earned on the capital invested on all of the projects that the firm has on its books - i.e. its assets in place. This can then be compared to the firm's cost of capital to conclude whether the firm has collectively invested in good projects. In practice, it is instructive to consider when return on capital is most likely to succeed at its mission: the operating income in the most recent year should be a good proxy of the typical operating earnings on existing investments and the book value should, in fact, capture the capital invested in these investments. As we will see in the next section, there is good reason to be skeptical about both these assumptions and the return on capital, at least as computed based upon accounting numbers, can be a poor measure of the quality of a firm's assets in place.

Return on Equity

While the return on capital measures the return on all capital invested in an asset, the return on equity focuses on just the equity component of the investment. It relates the earnings left over for equity investors after debt service costs have been factored in to the equity invested in the asset. The accounting definition of return on equity reflects this:

Much of what said about return on capital in terms of timing and book value applies to this measure as well. The net income from the current year is assumed to be generated by the equity investment at the start of the year and we use the book value of equity to measure the equity invested in existing assets.

6 This makes more sense if you are following a mid-year convention for your cash flows. In other words, rather than estimate cash flows at the end of year 1, 2, 3 and so on as is the usual practice, you estimate cash flows in half a year, 1.5 years from now, 2.5 years from now etc.

See Technical Indicators