Return on invested capital

Valuation multiples: Return on investment and growth

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Enterprise value multiples, such as EV/NOPAT and EV/EBITDA, can be derived from underlying value drivers, including growth, return on investment, and cost of capital. These calculations benefit from the rigour of an underlying DCF methodology but present the results as familiar valuation multiples.

Our popular target multiple calculator can be used in both absolute valuations and to derive value drivers implied by current market prices. In a new expanded version of the model we add a disaggregation of growth inputs and a more refined measure of return on investment. The interactive model is free to download.

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DCF versus residual income: A difference in returns

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Residual income based valuations are a useful alternative to the more common discounted cash flow. While both approaches must produce the same answer for a given set of assumptions and value drivers, we think it can be easier to derive realistic inputs using the residual income approach, considering the focus on return on investment.

However, residual income also poses challenges. The approach requires ‘clean surplus’ accounting, return inputs must allow for accounting distortions due to the lack of recognition of intangibles, and terminal growth assumptions may need to differ from those used in DCF – as we demonstrate using an interactive model.

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Missing intangible assets distorts return on capital

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The inconsistent and incomplete recognition of intangible assets in financial statements distorts performance metrics. Invested capital and profit are understated – to what extent depends on the business dynamics and nature and source of investment in intangibles. The combined effect is generally to overstate return on capital.

With the ever-increasing importance of intangible assets, few companies are unaffected by this accounting problem. We suggest adjustments to help your analysis, provide an interactive model to illustrate, and calculate an intangible asset adjusted return for Amazon.

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