Value Drivers

ROCE Drivers
ROCE is decomposed into drivers over three
levels of analysis:

1. Analysis of Leverage

1. Analysis of Operating Profitability

1. Analysis of Net Borrowing Costs

 First-Level Breakdown: Analysis of Effects of
Financial Leverage (FLEV)
Net Income
ROE =
Average CSE
(OI - Net Financial Expense)
=
NOA − NFO

So, ROCE is a weighted return to operating activities and financing activities:

or,  NOA   NFO 
ROCE =  x RNOA  -  CSE x NBC 
 CSE

 CSE + NFO   NFO 

ROCE =  x RNOA  -  CSE x NBC 
 CSE   

 NFO   NFO 
ROCE = 1 + x RNOA  -  CSE x NBC 
 CSE 
NFO
ROCE = RNOA + [ x (1RNOA - NBC
4 4 2 4 43
)]
CSE

FLEV Spread
RNOA = OI (After tax) / NOA (Return on Net Operating Assets)
FLEV = NFO / CSE (Financial Leverage)
NBC = NFE (after tax) / NFO (Net Borrowing Cost)
SPREAD = RNOA – NBC (Operating Spread)
 Financial Leverage:
ABC Company

NOA 12,572 OI 1,901

NFO 6,114 NFE 252
CSE (before MI) 6,458 CI 1,649

FLEV = 6,114/6,458 = 0.947 ROCE = 25.5%

RNOA = 15.1%
NBC = 4.1%

ROCE = RNOA + [FLEV × (RNOA – NBC)]

= 15.1% + [0.947 × (15.1% - 4.1%)]
= 25.5%
The Financial Leverage Equation
ROCE = RNOA + FLEV x [RNOA – NBC]

The equation says that ROCE is driven by three factors:

1. Profitability of Operations: RNOA

2. Financial Leverage: FLEV = NFO

CSE
3. Operating Spread: RNOA - NBC
 The Effects of Operating Liability
Leverage (OLLEV)
Operating liabilities lever the Return on Net Operating Assets
OI
RNOA =
OA - OL

What would be the operating profitability without operating liabilities?

OI + Implicit Interest (After Tax)
Return on Operating Assets (ROOA )= .
Operating Assets

where
Implicit Interest on Operating Liabilities (as a benchmark) = Short-term Borrowing Rate
(after tax) x Operating Liabilities

The Effect of OLLEV: RNOA = ROOA + (OLLEV x OLSPREAD)

OL
OLLEV =
NOA
where
OLSPREAD = ROOA − Short - term Borrowing Rate (after tax )
 Operating Liability Leverage: ABC Company

OA 18,124 OI 1,901
OL 5,552
NOA 12,572

OLLEV = 5,552/12,572 = 0.442

Short-term borrowing rate = 2.3% (after tax)

Implicit cost of operating liabilities = 5,552 × 0.023
= 127.7

1 ,901 + 127 .7
ROOA = = 11 . 2 %
18 ,124

RNOA = 11 . 2 % + [0 . 442 × (11 .2 %- 2 .3% )] = 15 . 1 %

Summing Financial Leverage and Operating Liability
Leverage Effects on ROCE

ROCE = ROOA + (RNOA – ROOA) + (ROCE – RNOA)

Return Effect of Effect of

with Operating Financing
no leverage Liabilities Liabilities

For ABC Company,

25.5% = 11.2% + (15.1% - 11.2%) + (25.5% - 15.1%)

= 11.2% + 3.9% + 10.4%
 Second-Level Breakdown of ROCE: Drivers of
Operating Profitability

ROCE = RNOA + [FLEV x (RNOA - NBC )]

↑
RNOA = PM × ATO

1. Operating profit margin: The profitability of each dollar of sales

PM = OI / Sales

2. Asset turnover: The ability to generate sales for a given asset base
ATO = Sales / NOA

3. Effect of financial leverage

Once More: A Summary
 Key Drivers : Select Industries

Industry Key economic factors Key ReOI drivers

Automobiles Model design and production Sales and margins

efficiency

Beverages Brand management and production Sales

innovation

Cellular phones Population covered and churn rates Sales and ATO

Commercial real estate Square footage and occupancy rates Sales and ATO

Computers Technology path and competition Sales and margins

Fashion clothing Brand management and design Sales and advertising/sales

Internet commerce Hits per hour Sales and ATO

Non fashion clothing Production efficiency Margins

Pharma Research and development Sales

Retail Retail space and sales per square foot Sales and ATO