Ebita

Invested capital

If we relate EBITA and invested capital to revenues, we get the equation:

ElilTA

Revenues

Invested capital Revenues Invested capital

Pre-tax ROIC is thus broken down into two components:

1. Operating margin (EBITA/Revenues) measures how effectively the company converts revenues into profits.

2. Capital turnover (Revenues/Invested capital) measures how effectively the company employs its invested capital.

Each of these components can be further disaggregated into their components where the expense or capital items are compared to revenues. Exhibit 9.8 shows how the components can be organized into an ROIC tree for Hershey.

The component measures of the return on invested capital are industry- and company-specific. For example, wholesalers typically have slim margins and high capital turnover, while telephone companies have high margins and low capital turnover. These ratios may also reflect the company's operating strategy relative to its competitors. Higher margins might compensate for lower capital turnover (although the best companies often outperform their competitors on all measures).

Once you have calculated the historical value drivers, analyze the results by looking for trends and comparing with other companies in the same industry. Try to assemble this into an integrated perspective that combines the financial analysis with an analysis of the industry structure (opportunities for differentiation, entry/exit barriers, etc.) and a qualitative assessment of the company's strengths and vulnerabilities.

Developing this integrated perspective is not a mechanical process, so it is difficult to generalize. But we can provide some examples:

• For consumer products companies with strong brand names, like Hershey Foods, you are likely to find high ROICs. The key issues tend to be about growth (market share, new products, managing the

Exhibit 9.8 Hershey Foods—1998 ROIC Tree1

distribution chain) and benchmarking performance against competitors (manufacturing costs, overhead, inventory management).

• For commodity companies, like paper or some chemical companies, you need to understand whether the company and the industry have been able to earn their cost of capital. In many cases they haven't. You then need to understand the short- and long-term supply/demand picture for the industry and evaluate competitor behavior. Try to identify where the industry is in its cycle and whether there are structural changes that will change the cycle permanently. Think about whether the company has any competitive advantages (technology, market access). Has the company been able to turn these advantages into higher returns than the industry average? How good a job has the company done at timing major capital expenditures?

While it is impossible to provide a comprehensive checklist for understanding a company's historical performance, here are some things to keep in mind:

• Look back as far as possible (at least ten years). This will help you to understand whether the company and the industry tend to revert to some normal level of performance and whether short-term trends are likely to be permanent breaks from the past.

• Go as deep into the value drivers as you can, getting as close to operational performance measures as possible.

• If there are any radical changes in performance, identify the source of the change and determine whether it is real or perhaps just an accounting effect and whether any change is likely to be sustained.

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