Aswath Damodaran on ROC, ROIC and ROE – Measurement and Implications
July 2007
If there has been a shift in corporate finance and valuation in recent years, it has been towards giving “excess returns” a more central role in determining the value of a business. While early valuation models emphasized the relationship between growth and value – higher growth firms were assigned higher values – more recent iterations of these models have noted that growth unaccompanied by excess returns creates no value. With this shift towards excess returns has come an increased focus on measuring and forecasting returns earned by businesses on both investments made in the past and expected future investments. In this paper, we examine accounting and cash flow measures of these returns and how best to forecast these numbers for any given business for the future.
The notion that the value of a business is a function of its expected cash flows is deeply engrained in finance. To generate these cashflows, though, firms have to raise and invest capital in assets and this capital is not costless. In fact, it is only to the extent that the cash flows exceed the costs of raising capital from both debt and equity that they create value for a business. In effect, the value of a business can be simply stated as a function of the “excess returns” that it generates from both existing and new investments.
While this principle is intuitive and easily proved, measuring excess returns has proved to be difficult to do. On one side of the equation are the costs of debt, equity and capital. While there are clearly significant questions that remain to be addressed, a significant portion of the research in finance has been directed towards estimating these numbers more precisely. On the other side of the equation are the returns themselves and surprisingly little has been done in coming up with a cohesive and consistent measure of returns generated on investments and how these returns can be expected to evolve over time.
In the first part of this paper, we will lay out what we are trying to measure with these returns and why it matters so much that we get a good estimate of the numbers. In the second part of the paper, we will look at both accounting and cash flow based measures of returns and the advantages and disadvantages of both. In the third part of the paper, we will consider factors that may cause the measured returns for a firm to deviate from its true returns and how best to fix the problems. In the fourth part of the chapter, we will turn our attention to forecasting investment returns and how best to incorporate the effects of competition into these forecasts.
Investment Returns: What and Why?
In finance and accounting, there are frequent references to returns on investments and different definitions of these returns. To better understand, what we are trying to
measure with investment returns, consider a financial balance sheet in figure 1.
Note the contrast to an accounting balance sheet, which is more focused on categorizing assets based upon whether they are fixed, current or intangible and recording them at accounting or book value estimates of value. Note also the categorization of assets in this balance sheet into assets in place and growth assets, thus setting up the two basic questions to which we need answered in both corporate finance and valuation:
a. How good are the firm’s existing investments? In other words, do they generate returns that exceed the cost of funding them?
b. What do we expect the excess returns to look like on future investments?
