Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

TRADITIONAL MEASURES OF PERFORMANCE

A number of financial ratios are traditionally used to evaluate a firm’s performance. These measures include return-on-investment and market-to-book (expressed by Tobin’s q) ratios. In this section we take a brief look at each of these ratios and how they are used to evaluate performance.

Return-on-Investment Ratios

Return-on-investment ratios compare the benefit from decisions (represented in the numerator) with the resources affecting that benefit (represented in the denominator). To evaluate how well the firm uses its assets in its operations, the basic earning power ratio, the ratio of earnings before interest and taxes (i.e., operating earnings) to total assets, can be used:

(3.1)

For example, a basic earning power ratio of 25 percent means that for every dollar invested in assets, the firm generates 25 cents of operating profit. Because this measure deals with earnings from operations, it does not consider how these operations are financed; that is, the earnings before interest and taxes are available to pay both creditors and owners.

Another return-on-investment ratio, return on assets, uses net income (i.e., operating earnings less interest and taxes) in comparison with total assets:

(3.2)

This ratio shows the return available to owners ...