CONFIDENTIAL

Performance Management from

ROE to CFROI
Greg Collett
greg.collett@credit-suisse.com
+44 207 88 33 643

Market Commentary

Prepared for training purposes. This document has been prepared for your information and use
only. It should only be distributed to other members of your organization on a need-to-know basis
and is not meant for distribution or dissemination to any other person or entity.

CONFIDENTIAL

Comparison of Financial Performance Metrics

Cash Flow
Return on
Investment
Cash Return on
Inflation
Adjusted Gross
Investment

Cash Return on
Gross
Investment

Return on
Invested
Capital

ROIC
Return on
Equity

ROE

CROGI

CROIGI

CFROI

CONFIDENTIAL

Return on Equity
!
!

ROE is defined as Net Earnings / Book Equity.

It is an incomplete measure.

CFROI

CROIGI

CROGI

ROIC
Return on
Equity

ROE

Return on Equity - Issues

You are an investor..

" Can ROE be used to compare a single
companys performance year on year?
" Can ROE be used to compare
European and US companies across
time?

CONFIDENTIAL

Return on Equity Changing Leverage Adds Noise to the Signal

Income

CONFIDENTIAL

1,000

1,000

1,000

1,000

1,000

1,000

1,000

1,000

1,000

1,000

1,000

Costs

700

700

700

700

700

700

700

700

700

700

700

EBIT

300

300

300

300

300

300

300

300

300

300

300

Interest

100

90

80

70

60

50

40

30

20

10

PBT

200

210

220

230

240

250

260

270

280

290

300

Tax

60

63

66

69

72

75

78

81

84

87

90

140

147

154

161

168

175

182

189

196

203

210

1,000

900

800

700

600

500

400

300

200

100

100

200

300

400

500

600

700

800

900

1,000

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

NA

147%

77%

54%

42%

35%

30%

27%

25%

23%

21%

Net Income
Debt
Equity
Debt/(Debt + Equity)
ROE

160%

1,200

140%

1,000

120%
800

100%
80%

600

60%

400

40%
200

20%
0%

0
1

6
Debt

7
Equity

8
ROE

10

CONFIDENTIAL

Understanding Inflations Impact on ROE

LIFO
Revenue
- Expenses
Profit
ROE

Net Income

Owners Equity

Inventory
Wages

FIFO

Depreciation

CONFIDENTIAL

Inflation Can Seriously Distort ROE

20

Reported
ROE

Reported ROE
using actual
U.S. inflation for
a 6% real IRR
project.

15

10

6% IRR Project
(Inflation Adjusted)

0
1870

1880

1890

1900

1910

Source: HOLT analysis

1920

1930

1940

1950

1960

1970

1980

1990

CONFIDENTIAL

Return on Invested Capital

!

ROIC is defined as NOPAT / Invested Capital and is key to Economic Profit

analysis.

CFROI

CROIGI

Return on
Invested
Capital

ROIC

ROE

CROGI

CONFIDENTIAL

Return on Invested Capital

Operating Profit (EBIT)

- Effective Tax Charge
= NOPAT (Net Operating Profit After Tax)

ROIC =

NOPAT
Invested Capital
Total Assets
- Payables
- Other Current Liabilities
- Cash
= Invested Capital

CONFIDENTIAL

Return on Invested Capital Issues

Current Dollar income which includes

noncash items such as depreciation
and amortisation

ROIC =

NOPAT
Invested Capital

Can we expect this ratio to

tell us anything useful about
performance?
NOPAT and Invested Capital
are not in constant dollars!

Historical cost depreciated assets

Excludes off balance sheet items

CONFIDENTIAL

Accounting Items Can Distort the Return Calculation

Example: Two Plants

Managers A and B operate plants of equal capacity but with different

ages

Plants each have 20 year life, original cost of assets = 1,000

Plant A

Plant B

NOPAT

100

100

Age of Assets

10

Invested
Capital

500

1,000

ROIC

20%

10%

Manager B is
penalized for
having a newer
plant!

Worldwide Accounting and Reporting Issues Prevent Comparability

Australia/

CONFIDENTIAL

United
Kingdom

Germany

France

(GBR)

(DEU)

(FRA)

(NLD)

(CHE)

(JPN)

New
Zealand
(AUS/NZL)

Minority Interest

Minor

Extensive

Extensive

Minor

Extensive

Extensive

Minor

Extensive

Goodwill

Written-off

Capitalized Capitalized Written-off Capitalized

Capitalized

Capitalized

Both

Revaluations

Extensive

Non-issue

Non-issue

Non-issue

Non-issue

Not Allowed

Extensive

Minor

Share Classes

Non-issue

Extensive

Non-issue

Non-issue

Extensive

Non-Issue

Minor

Non-issue

Depreciation

Straight
Line

Accelerated

Investments

Minor

Extensive

Region Specific

Reserve
Accounting

Source: HOLT research

Netherlands Switzerland Japan

Mix

Mix
Mostly S/L

Extensive

Minor

Mix

Minor

Accelerated

Mix
Mostly S/L

Extensive

Consolidated
Accounting

Minor

South Africa
(ZAF)

Straight
Line

Extensive
Cross
Holdings

CONFIDENTIAL

Cash Return on Gross Investment

CFROI

Cash Return on
Gross
Investment

CROGI

ROIC

ROE

CROIGI

CONFIDENTIAL

Cash Return on Gross Investment

NOPAT
+Depreciation
+Other non-

Operating After
Tax Cash Flow
CROGI

cash items

Gross Investment
Invested Capital
+

ROIC

Accumulated
Depreciation
+

ROE

Capitalized
Expenses

... by adding back non-cash items to NOPAT and accumulated depreciation to

Invested Capital
This captures the total value of investment in the asset base more accurately

CONFIDENTIAL

Cash Return on Gross Investment

Example: Two Plants

Plant A

Plant B

NOPAT

100

100

Depreciation

50

50

Operating After Tax

Cash Flow

150

150

Invested Capital

500

1,000

Accumulated
Depreciation

500

Gross Investment

1,000

1,000

CROGI

15%

15%

CROGI shows that

managers A and B
are achieving
similar cash
returns on the
original
investment!

Cash Return on Gross Investment

From an investors point of view..

What is the impact of inflation on the
investment made ten years ago?
Are you measuring return on what you
spent ten years ago or on what that
investment is worth in todays money
(current Dollars)?

CONFIDENTIAL

Differing Inflation Rates Make International Comparisons Difficult

!

Can you use CROGI to compare companies across time and in different
countries?

CONFIDENTIAL

CONFIDENTIAL

Cash Return on Inflation Adjusted Gross Investment

!

CROIGI is defined as Cash Return / Inflation Adjusted Gross Investment.

Cash Return on
Inflation
Adjusted Gross
Investment

CROIGI

CROGI

ROIC

ROE

CFROI

CONFIDENTIAL

Cash Return on Inflation Adjusted Gross Investment

Operating After Tax

CROIGI =

Operating After
Tax Cash Flow
Inflation Adjusted
Gross Investment

Cash Flow

Gross Investment +
Inflation Adjustment

CROGI

on Gross Investment

ROIC
ROE

... by adding an inflation adjustment to the gross fixed assets to

approximate their value in todays money.
This gives a fair value to the entire asset base, regardless of age.

CONFIDENTIAL

Cash Return on Inflation Adjusted Gross Investment

Example: Two Plants

Operating After
Tax Cash Flow
Gross
Investment
Age
Inflation
Adjustment*
Inflation Adjusted
Gross Investment
CROIGI

Plant A

Plant B

150

150

1,000

1,000

10

220

1,220

1,000

12%

15%

* Assuming 2% Annual Inflation

CROIGI shows that

plant As return is
actually less than
Bs when the value
of investment is
compared in
todays money!

CONFIDENTIAL

Cash Return on Inflation Adjusted Gross Investment

What if two projects with the same return

have different lives?
How do you select the correct one?
For the same investment would you
choose a 10% project with a 5 year life or
a 10 year life?

CONFIDENTIAL

Cash Flow Return On Investment (CFROI)

Cash Flow
Return on
Investment

CFROI

CROIGI

CROGI

ROIC

ROE

CONFIDENTIAL

Why Is Life Important?

Gross Cash
Flow

50

10
10% return?
Life = 4 Years

Current
Gross
Investment

100
CFROI = - 3.1%

Life helps measure the economic return

earned today, by forecasting how much cash
flow will be received over a realistic time
period.
Consider a 100 investment that earns 10 in
cash flows for 4 years. The CROIGI return
looks like 10% (10/100), yet when life is
considered, the economic return (CFROI) is
negative.

CONFIDENTIAL

Why Is Life Important?

Consider that same 100 investment that earns 10 in cash flows for 30
years. The CROIGA return looks like 10%, however, the cash flows are
forecasted to last 30 years, making the economic return 9.68%.

50

Infl. Adj.
Gross Cash
Flow

Non-Depreciating
Asset Release

10

10% return?
Life = 30
Years

Current
Gross
Investme
nt

100

CFROI = 9.68%

CONFIDENTIAL

CFROI Not Distorted By Asset Mix

20
10

Machine Tools

IRR = 3.0%
10 Years

100
75
Distribution Company

10
IRR = 8.3%
10 Years

100

CONFIDENTIAL

Why Is It Important to Adjust for Inflation?

Life (years)
Year
USA inflation
SA inflation
Avg. exchange rate

10
1991
3.9%
13.5%
2.76

1992
2.8%
12.7%
2.85

1993
2.6%
10.4%
3.27

1994
2.4%
9.8%
3.55

1995
2.5%
8.8%
3.63

1996
2.3%
8.4%
4.30

1997
1.6%
7.8%
4.61

1998
0.6%
7.7%
5.55

1999
1.4%
6.8%
6.12

2000
2.2%
6.2%
6.94

Analysis in US$
Cost in US$
Accumulated depreciation
Net asset value
GCF
ROIC
ROGI
Inflation-adjusted cost
CFROI

1,000
100
900
150
15%
15%
1,000
8%

1,000
200
800
154
17%
15%
1,028
8%

1,000
300
700
158
20%
16%
1,055
8%

1,000
400
600
162
23%
16%
1,080
8%

1,000
500
500
166
28%
17%
1,107
8%

1,000
600
400
170
34%
17%
1,133
8%

1,000
700
300
173
43%
17%
1,151
8%

1,000
800
200
174
58%
17%
1,158
8%

1,000
900
100
176
88%
18%
1,174
8%

1,000
1,000
0
180
180%
18%
1,200
8%

Analysis in ZAR
Price in US$
Cost in rand
Accumulated depreciation
Net asset value
GCF
ROIC
ROGI
Inflation-adjusted cost
CFROI

FALSE
Yes?
2,760
276
2,484
414
15%
15%
2,760
8%

2,760
552
2,208
467
19%
17%
3,111
8%

2,760
828
1,932
515
23%
19%
3,434
8%

2,760
1,104
1,656
566
29%
20%
3,771
8%

2,760
1,380
1,380
615
37%
22%
4,102
8%

2,760
1,656
1,104
667
48%
24%
4,447
8%

2,760
1,932
828
719
65%
26%
4,794
8%

2,760
2,208
552
774
94%
28%
5,163
8%

2,760
2,484
276
827
150%
30%
5,514
8%

2,760
2,760
0
878
318%
32%
5,856
8%

1.00
1.00

1.03
1.13

1.05
1.24

1.08
1.37

1.11
1.49

1.13
1.61

1.15
1.74

1.16
1.87

1.17
2.00

1.20
2.12

GP factor in USA
GP factor in SA

Notes
1. A South African company buys an asset in US$ in 1991 and places it on its books in ZAR. The asset does not get re-valued.
2. The company produces a profit stream that can be priced in US$ or ZAR, i.e., products are sold at a local price or a global commodity price
3. It was assumed that the NDA is zero for the CFROI calculation.

CONFIDENTIAL

Adjustments Are Essential to True Economic Performance Measurement

Cash Flow
Return on
Investment

CFROI

CROIGI

CROGI

ROIC

ROE

Adjustments

CONFIDENTIAL

From Cash To CFROI (Internal Rate of Return)

Net Income (Before Extraordinary Items)
+/- Special Items (after tax)
+ Depreciation/Amortization Expense
+ Interest Expense
+ R&D Expense
+ Rental Expense
+ Minority Interest Expense
+ Net Pension Cash Flow Adjustment
+ LIFO charge to FIFO Inventory
+ Monetary Holding Gain/Loss
- Equity Method Investment Income
10

Net Monetary Assets

+ Inflation Adjusted Land & Improvements
+ Investments (Non-Equity Method )
+ Inventory (w/ LIFO Inventory Reserve)
+ Other LT Assets less Pension Assets
25

Non-Depreciating Assets

Gross Cash Flow

CFROI = 6.0%
13-Year Asset Life

100
Inflation Adjusted
Gross Investment

Net Book Assets

+ Accumulated Depreciation
+ Inflation Adjustment to Gross Plant
+ LIFO Inventory Reserve
+ Capitalized Operating Leases
+ Capitalized R&D
- Equity Method Investments
- Pension Assets
- Goodwill
- Non-Debt Monetary Liabilities & Deferred
Taxes

CONFIDENTIAL

Rules for Value Creation What is Good Growth?

Managing for shareholder value requires an understanding of the trade-off between

cash flow returns and growth. Capital should be allocated to positive spread
businesses and projects that are creating value. Marginal businesses should
concentrate on improving operating efficiencies instead of growth.

Cash Flow
Return
CFROI%

Positive
Spread
Business

Discount Rate
(Cost of Capital)
Neutral
Spread
Business

Strategic
Options

Increase
CFROI

Increase
CFROI

Hold CFROI
and Grow
Assets

Then grow

Negative
Spread
Business

Increase CFROI
Reduce
Reinvestment
Divest or Liquidate

CONFIDENTIAL

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Backtested, hypothetical or simulated performance results have inherent limitations. Simulated results are achieved by the retroactive application of a backtested model itself
designed with the benefit of hindsight. The backtesting of performance differs from the actual account performance because the investment strategy may be adjusted at any time, for
any reason and can continue to be changed until desired or better performance results are achieved. Alternative modeling techniques or assumptions might produce significantly
different results and prove to be more appropriate. Past hypothetical backtest results are neither an indicator nor a guarantee of future returns. Actual results will vary from the
analysis.
With respect to the analysis in this report based on the HOLT methodology, Credit Suisse certifies that (1) the views expressed in this report accurately reflect the HOLT
methodology and (2) no part of the Firms compensation was, is, or will be directly related to the specific views disclosed in this report. The HOLT methodology does not assign
ratings to a security. It is an analytical tool that involves use of a set of proprietary quantitative algorithms and warranted value calculations, collectively called the HOLT valuation
model, that are consistently applied to all the companies included in its database. Third-party data (including consensus earnings estimates) are systematically translated into a
number of default variables and incorporated into the algorithms available in the HOLT valuation model. The source financial statement, pricing, and earnings data provided by
outside data vendors are subject to quality control and may also be adjusted to more closely measure the underlying economics of firm performance. These adjustments provide
consistency when analyzing a single company across time, or analyzing multiple companies across industries or national borders. The default scenario that is produced by the
Credit Suisse HOLT valuation model establishesthe baseline valuation for a security, and a user then may adjust the default variables to produce alternative scenarios, any of which
could occur. The HOLT methodology does not assign a price target to a security. The default scenario that is produced by the HOLT valuation model establishes a warranted price
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January 29 2008