Understanding Return Ratios and Their Relationship to Earnings Quality and Equity Valuation

By Paul B. Finch, MBA | 7/10/2024

As competition in the Beverage Alcohol Industry continues to put downward pressure on profit margins among constituent firms, especially in the Wine segment, it is now more important than ever for business managers to assess the effectiveness of their business’ strategies and tactics in order to ensure the long-term sustainability of their core business operations.

This begs the question of how you should assess business performance, especially during periods of systematic change. Basic bookkeeping practices teach us to focus on Accounting Profits, that is Total Revenue - Operating Expense = Profit to assess business performance. In this way of thinking, as long as you are able to earn sufficient revenue to exceed operating expenses, your business is effective. So, what’s wrong with this approach since we are all, at some level, accustomed to talking about Accounting Profit? The problem with focusing exclusively on Accounting Profit is that it ignores the question of what constitutes an acceptable level of profit. To understand how you should gauge profitability, you need to utilize a different measure of profitability than what Accounting Profits can offer. Economic Profits, that is Total Revenue - Operating Expense - Opportunity Cost = Profit, provides a means of determining acceptable levels of profitability, specifically, profitability that exceeds your business’ Opportunity Cost as measured by its Required Rate of Return.

Economic Profit is an important concept to embrace because businesses, and business managers, that are successful at generating Economic Profits are providing Cash Flow to their owners/investors in excess of their Cost of Capital and are therefore exceeding their Required Rate of Return. These businesses will trade/sell at a premium as well as find it easier to raise capital in support of growth. Return Ratios allow you to measure whether your business is generating Economic Profits.

What Are Return Ratios?

Return Ratios measure the effectiveness of your business’ performance relative to profitability and risk as expressed by your business’ Required Rate of Return - the riskier the investment the greater the Required Rate of Return [but also the greater the opportunity for increased earnings]. While Return Ratios allow business owners to compare their Earnings to that of other competitor companies, the real advantage in measuring Return Ratios is to compare your business’ Earnings to your Cost of Capital which represents your business’ Required Rate of Return.

Measuring Return on Investment

While there are many different methods of measuring Return Ratios, two methods stand-out as the most useful for assessing business performance:

1. Return on Invested Capital (ROIC)

ROIC focuses on the relationship between Operating Income (after tax) and Operating Capital, that is both the debt and equity in your business’ capital structure.

Because it is generally understood that operating activities represent the most persistent and relevant measures for determining business performance, that is the income, expense, assets and liabilities that are necessary to support the ongoing core operations of your business, ROIC requires the segregation of financial statements (balance sheet and income statements) between operating and nonoperating components. Nonoperating assets and liabilities result most commonly from investments in marketable securities, and loans to outsiders whereas nonoperating income and expense result most commonly from interest income and expense as well as gains and losses from the disposal of assets and marketable securities. All nonoperating activities should be excluded from the computation of ROIC.

ROIC is calculated as follows:

ROIC = Net Operating Profit after Tax / Net Operating Capital

(Based on a 12-month lookback period)

As a performance benchmark, ROIC should always be compared to your Business’ Weighted Average Cost of Capital (WACC) which is the weighted average cost of debt and equity in your business’ capital structure. When your business’ ROIC is greater than your WACC, then management is earning an Economic Profit by providing returns in excess of what investors would otherwise require. These businesses have greater equity value.

Conversely, if your business’ ROIC is less than your WACC, then management is destroying value because returns are less than the cost of capital. Under these circumstances, investors should be able to obtain a greater return from alternative investments with the same or similar risk. When your business’ ROIC is less than your WACC, management needs to take action to remedy the situation because returns less than your WACC are neither desirable nor sustainable in the long-run.

Traditionally, Net Operating Capital is measured by adding up the actual amount of invested capital provided through debt or equity investments. However, by utilizing this approach, you will not be able to measure business performance for divisions or segments as referenced above. That is why I prefer to calculate Net Operating Capital as the sum of Net Operating Working Capital [Operating Current Assets minus Operating Current Liabilities] + Net Fixed Assets [Property, Plant and Equipment Net of Depreciation]. I prefer this approach because it allows me the option to perform this calculation for a division or segment within a business to assess the relative effectiveness of these divisions or segments. That said, either approach should provide you with the same value as long as excess cash, that is cash in excess of that required to support operations, is excluded from both calculations.

2. Return on Common Equity (ROCE)

ROCE focuses on the relationship between net income and common shareholder equity and, thereby, excludes debt from its calculation. The focus on common shareholder equity is designed to isolate returns specific to the funders of equity capital.

ROCE is computed as follows:

ROCE = Net Income Available to Common Stockholders / Common Equity

(Based on a 12-month lookback period or the average of two 12-month lookback periods).

As a performance benchmark, ROE should always be compared to your Business’ Cost of Equity Capital. As with ROIC, when your business’ ROE is greater than your Cost of Equity Capital, then management is earning an Economic Profit by providing returns in excess of what investors would otherwise require. These businesses have greater equity value.

However, as with ROIC, if your business’ ROCE is less than your Cost of Equity Capital, then management is destroying value because returns are less than the cost of capital. Under these circumstances, investors should be able to obtain a greater return from alternative investments with the same or similar risk. When your business’ ROE is less than your Cost of Equity Capital, management needs to take action to remedy the situation because returns less than your ROE are neither desirable nor sustainable in the long-run.

Additional Thoughts

Measures of ROIC and ROCE are not restricted for use in historical lookback periods. In fact, measures of ROIC and ROE can be utilized very effectively in forward-looking budgeting exercises to assess projected business performance.

For me, measuring ROIC is more meaningful than measuring the ROE when assessing the effectiveness of business performance. This is because the calculation of ROIC focuses on a business’ operating activities which tend to be more persistent and therefore more indicative of current and future financial performance. Conversely, ROCE measures results from nonoperating activity which can include one-time, extraordinary income and expense transactions that are not recurring. As such, users of ROCE as their primary measure of Return on Investment need to be cautious about drawing faulty conclusions about a business’ long-term prospects.

That said, ROCE calculations can be very useful in certain business valuation assessments. In a business valuation context, ROCE is computed as Free Cash Flow to Equity divided by the Cost of Equity Capital. However, business valuation analysts still need to overcome the fact that ROCE calculations intrinsically measure results from nonoperating activity. This being the case, business valuation analysts, utilizing Free Cash Flow to Equity as a measurement of earnings, must recast and adjust underlying financial statements to eliminate the effects of all non-operational and non-persistent transactions in order to derive valid results.

Paul B. Finch, MBA, is co-founder and Executive Director for Benchmark Solutions, Inc. and is an accomplished Strategic Financial Advisor. Professionally, Paul has focused his career on the various facets of corporate finance that revolve around the creation and measurement of equity value for his clients. Paul’s work includes both domestic and international merger and acquisition engagements as well as projects specifically designed for the purpose of increasing profitability, earnings quality, and growth prospects (while limiting risks and exposures) for his clients. Paul is a recognized subject matter expert in Financial Planning & Analysis, Capital Acquisition, Business Valuation as well as Merger and Acquisition Advisory and has published many articles pertaining to these topics. You can contact Paul at paul.finch@benchmarksolutions.us.com