The Little Book of Valuation

Measures of Profitability

Although the income statement allows us to estimate how profitable a firm is in absolute terms, it is just as important that we gauge the profitability of the firm in comparison terms or percentage returns. The simplest and most useful gauge of profitability is relative to the capital employed to get a rate of return on investment. This can be done either from the viewpoint of just the equity investors or by looking at the entire firm.

I. Return on Assets (ROA) and Return on Capital (ROC)

The return on assets (ROA) of a firm measures its operating efficiency in generating profits from its assets, prior to the effects of financing.

Earnings before interest and taxes (EBIT) is the accounting measure of operating income from the income statement, and total assets refers to the assets as measured using accounting rules, that is, using book value for most assets. Alternatively, ROA can be written as

By separating the financing effects from the operating effects, the ROA provides a cleaner measure of the true return on these assets.

ROA can also be computed on a pretax basis with no loss of generality, by using the EBIT and not adjusting for taxes:

This measure is useful if the firm or division is being evaluated for purchase by an acquirer with a different tax rate or structure.

A more useful measure of return relates the operating income to the capital invested in the firm, where capital is defined as the sum of the book value of debt and equity, net of cash and marketable securities. This is the return on capital (ROC). When a substantial portion of the liabilities is either current (such as accounts payable) or non–interest-bearing, this approach provides a better measure of the true return earned on capital employed in the business.

The ROC of a firm can be written as a function of its operating profit margin and its capital turnover ratio:

Thus, a firm can arrive at a high ROC by either increasing its profit margin or more efficiently using its capital to increase sales. There are likely to be competitive and technological constraints on increasing sales, but firms still have some freedom within these constraints to choose the mix of profit margin and capital turnover that maximizes their ROC. The return on capital varies widely across firms in different businesses, largely as a consequence of differences in profit margins and capital turnover ratios.

II. Return on Equity

Although ROC measures the profitability of the overall firm, the return on equity (ROE) examines profitability from the perspective of the equity investor by relating profits to the equity investor (net profit after taxes and interest expenses) to the book value of the equity investment.

Because preferred stockholders have a different type of claim on the firm than common stockholders, the net income should be estimated after preferred dividends, and the book value of common equity should not include the book value of preferred stock.