Session 9: Decentralisation and Performance Evaluation; ROI, RI & EVA Flashcards
What is ROI?
Return on investment (ROI) is a financial metric of profitability that is widely used to measure the return or gain from an investment. ROI is a simple ratio of the gain from an investment relative to its cost. It is as useful in evaluating the potential return from a stand-alone investment as it is in comparing returns from several investments. In business analysis, ROI is one of the key metrics—along with other cash flow measures such as internal rate of return (IRR) and net present value (NPV)—used to evaluate and rank the attractiveness of a number of different investment alternatives. ROI is generally expressed as a percentage rather than as a ratio.
- Return on investment (ROI) is a rough measure of an investment’s profitability.
- The metric has a wide range of interpretations, such as the profitability of stock investment, purchasing a new manufacturing plant, or the result of a real estate transaction.
- The ROI is calculated by dividing the net return on investment by the cost of investment and multiplying by 100% or by subtracting the initial value of the investment from the final value of the investment, dividing this new number by the cost of the investment and multiplying it by 100%.
- ROI is comparatively easy to calculate and understand, and its simplicity means that it is a standardized, universal measure internationally.
- On the downside, ROI doesn’t account for how long an investment is held, making comparing investments less useful to an investor than a measure that incorporates the holding period.
What is the formula for ROI?
ROI = Income / Invested Capital =
= Profit Margin x Investment Turnover
Where Profit Margin = Income/Sales
Investment Turnover = Sales/Invested Capital
For a single-period review, return on investment = (gain from investment – cost of investment) / cost of investment or return on investment = (revenue − cost of goods sold) / cost of goods sold
What is the DuPont Analysis?
The DuPont analysis (also known as the DuPont identity or DuPont model) is a framework for analyzing fundamental performance popularized by the DuPont Corporation. DuPont analysis is a useful technique used to decompose the different drivers of return on equity (ROE). The decomposition of ROE allows investors to focus on the key metrics of financial performance individually to identify strengths and weaknesses. There are three major financial metrics that drive return on equity (ROE): operating efficiency, asset use efficiency and financial leverage. Operating efficiency is represented by net profit margin or net income divided by total sales or revenue. Asset use efficiency is measured by the asset turnover ratio. Leverage is measured by the equity multiplier, which is equal to average assets divided by average equity. KEY TAKEAWAYS - The DuPont analysis is a framework for analyzing fundamental performance originally popularized by the DuPont Corporation. - DuPont analysis is a useful technique used to decompose the different drivers of return on equity (ROE). - An investor can use analysis like this to compare the operational efficiency of two similar firms. Managers can use DuPont analysis to identify strengths or weaknesses that should be addressed.
What is the formula for DuPont Analysis?
ROE = (Profit margin)*(Asset turnover)*(Equity multiplier) = (Net profit/Sales)*(Sales/Average Total Assets)*(Average Total Assets/Average Equity) = (Net Profit/Equity) Or Profit/Sales*Sales/Assets=Profit/Assets*Assets/Equity Or ROS*AT=ROA*Leverage=ROE Profitability (measured by profit margin) Asset efficiency (measured by asset turnover) Financial leverage (measured by equity multiplier)
What are some of the key challenges with ROI?
One of greatest risks associated with the traditional ROI calculation is that it does not fully “capture the short-term or long-term importance, value, or risks associated with natural and social capital”, because it does not account for the environmental, social and governance performance of an organization. Without a metric for measuring the short- and long-term environmental, social and governance performance of a firm, decision makers are planning for the future without considering the extent of the impacts associated with their decisions. ROI may lead to attractive investment opportunities being rejected if their ROI is below an existing high ROI. Equally, an underperforming division may accept a project that improves its ROI, even if project’s return is below Group’s cost of capital.
How does Residual Income address ROI’s weakness?
• Residual Income (RI) is an absolute (not %) measure • RI recognizes that accounting profit only deducts the cost of debt (not equity) funding. • RI attempts to measure the “real” profit by deducting a weighted average ‘hurdle’ cost for all sources of funds.
What is Residual Income?
Residual income is excess income generated more than the minimum rate of return. Residual income is a measurement of internal corporate performance, whereby a company’s management team evaluates the income generated relative to the company’s minimum required return. However, in personal finance, residual income is the level of income an individual has after the deduction of all personal debts and expenses paid. KEY TAKEAWAYS - Personal residual income is not the result of a job or hourly wages—it requires an initial investment either of money or time with the primary objective of earning on-going revenue. - Residual income is regularly referred to as “passive income” for individuals or businesses. Examples of residual income include real estate investing, stocks, bonds, investment accounts, and royalties. - For equity valuations, equity charge is calculated as the equity capital multiplied by the cost of equity. Corporate residual income is leftover profit after paying all costs of capital.
What is NOPAT?
Net Operating Profit After Tax
*it excludes interest expense, which is non-operating, therefore we must add interest expense back to net income and adjust after tax expense accordingly
There are many ways of measuring ‘income’ but the common practice of many compnies is to measure investment centre income as NOPAY.
What is the formula for residual income?
Investment center profit (NOPAT) – Investment charge = Residual income
What is the formula for investment charge?
Capital invested (Total Assets – NIBCL) × Cost of capital (WACC) = Investment charge
What is the formula for WACC?
WACC= [E/V]∗Re+[D/V]∗Rd∗(1−Tc)
where:
Re = Cost of equity
Rd = Cost of debt
E = Market value of the firm’s equity
D = Market value of the firm’s debt
V = E + D = Total market value of the firm’s financing
E/V = Percentage of financing that is equity
D/V = Percentage of financing that is debt
Tc = Corporate tax rate
What is Non-Interest-Bearing Current Liability (NIBCL)?
As the name suggests, a non-interest-bearing current liability (NIBCL) is a category of debt that an individual or a company must pay off within the calendar year–including taxes and accounts payable, where the liabilities in question do not require interest payments to be made. On a balance sheet, NIBCLs are siloed under the liabilities column, specifically filed under the “current liabilities” section.
What is economic value added (EVA)?
Economic value added (EVA) is a measure of a company’s financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis. EVA can also be referred to as economic profit, as it attempts to capture the true economic profit of a company. This measure was devised by management consulting firm Stern Value Management, originally incorporated as Stern Stewart & Co.
EVA is the incremental difference in the rate of return over a company’s cost of capital. Essentially, it is used to measure the value a company generates from funds invested into it. If a company’s EVA is negative, it means the company is not generating value from the funds invested into the business. Conversely, a positive EVA shows a company is producing value from the funds invested in it.
What is the formula for calculating EVA?
EVA = Net Operating Profit After Taxes (NOPAT) - Invested Capital * Weighted Average Cost of Capital (WACC)
What are the components of EVA?
The equation for EVA shows that there are three key components to a company’s EVA: NOPAT, the amount of capital invested, and the WACC. NOPAT can be calculated manually but is normally listed in a public company’s financials. Capital invested is the amount of money used to fund a specific project. WACC is the average rate of return a company expects to pay its investors; the weights are derived as a fraction of each financial source in a company’s capital structure. WACC can also be calculated but is normally provided as public record.
An equation for invested capital often used to calculate EVA is = Total Assets - Current Liabilities, two figures easily found on a firm’s balance sheet. In this case, the formula for EVA is: NOPAT - (Total Assets - Current Liabilities) * WACC.
The goal of EVA is to quantify the charge, or cost, of investing capital into a certain project or firm and to then assess whether it generates enough cash to be considered a good investment. The charge represents the minimum return that investors require to make their investment worthwhile. A positive EVA shows a project is generating returns in excess of the required minimum return.
