Analysis 53: Return on Investment

PURPOSE: This analysis enables the company to evaluate its Return on Investment compared to each of its competitors. This analysis identifies the low-cost competitor in the market place and helps set reasonable performance targets for the next three years.

APPROACH: Most of this analysis comes from examination of publicly available information. There are three measures of Return on Investment that may prove useful. The first is Return on Equity (ROE). Return on Equity is the result of dividing the profit after tax of a competitor by the sum of its total shareholder' equity. The second is Return on Net Caplital Employed (RONCE). The Return on Net Capital Employed (RONCE) is the result of dividing the EBIT of a competitor by the sum of its total debt plus equity, the Net Capital Employed (NCE).

In many industries, information is available on a business line basis, where companies allocate operating profits, assets and sales to a business line described by SIC code. These data provide more accurate pictures of the pure returns of competitors in an industry. Where this level of data is available, the measure used for this analysis is Return on Assets (ROA), which is operating profits divided by total allocated assets.

The Company with the lowest overall cost position will have the highest pretax Return on Assets (ROA) or Return on Net Capital Employed (RONCE) or Return on Equity (ROE). The Company would use the competitor with the highest returns to benchmark and evaluate its own operations.

• Self Test #24: Identifying Shortfalls in Financial Performance

• Worksheet #24: Identifying Shortfalls in Financial Performance

Return to Diagnose Costs: Measuring Current Shortfalls in Financial Markets

Return to Basic Strategy Guide Step 24

Analyses:

• Analysis 54: Operating Margin

• Analysis 55: Capital Intensity

Videos:

• Video #48: Competition, Cost and the Advantages of Low-Cost

• Video #24: Price Point Specialists in Hostility

• Video #75: Overview of Costs Part 1: How to Look

Symptoms and Implications: Symptoms developing in the market that would suggest the need for this analysis.

• The industry is reducing costs aggressively

• Some industry leaders have lower returns than the smaller competitors

Perspectives: Conclusions we have reached as a result of our long-term study and observations.

• "Costs: The Last Consideration"
  As margins fall and profitability slides, the obvious first response is to cut cost. Knowing why that may be the wrong choice requires an understanding of the difference between effective cost control in hostile and non-hostile markets. (1995)

• "Cutting The Right Cost"
  When markets turn hostile, managers turn to cost cutting. Reducing cost seems like the most direct route to improving profitability. Often, though, efforts to control costs make the situation worse. (1991)

• "Is Bigger Really Better?"
  In the average large industry, the market share leader is only slightly more likely to lead the industry than is any one of the next three competitors in the industry. Market share leaders often fail to become return leaders because they serve some customers who yield low returns and rely on size alone to create economies of scale. (1998)

• "What Makes Returns High?"
  At any point in time, most high returns can be traced to external factors that enable the company to charge high prices. Management really can not claim credit. Long term high returns, however, usually are the result of management efforts to control cost. (1993)