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Stanford Business magazine

 

Decoding Business Profitability

For years, return on investment (ROI) and related financial accounting ratios have been widely used as key measures of business profitability. Now three Business School accounting professors have written an award-winning paper that shows the economic interpretation of the ROI metric requires more careful analysis.

SolimanReichelsteinRajan

From left, Mark Soliman,
Stefan Reichelstein,and Madhav Rajan

For more than 40 years, business professionals and academics have relied on ROI to infer a company’s economic rate of return, which is usually conceptualized as the internal rate of return of a firm’s investment projects. Many recognized that financial accounting is subject to biases that could skew the magnitude of the ROI ratio, but they tended to believe these effects would average out over time, thereby enabling parity between ROI and real economic return. On the other hand, when companies such as those in the oil industry have been accused of abusing their market power, as evidenced by excessive accounting profitability, they tried to explain away high accounting returns by claiming that standard metrics do not adequately measure real economic returns.

“There wasn’t a precise mathematical understanding of the issue,” said Madhav Rajan, a professor of managerial accounting who collaborated on the study with Stefan Reichelstein, who also specializes in managerial accounting, and Mark Soliman, a financial accountant.

The threesome developed a model that enabled them to examine analytically and empirically how a firm’s ROI was affected by two central variables: accounting conservatism and growth in new investments. They considered accounting to be conservative if it resulted in book values that were understated because investments were written off faster than they should be, given the under-lying pattern of project cash flows. Direct expensing of intangible investments is a prime example of such conservatism.

The researchers found that accounting conservatism and past growth in investments jointly determined how ROI compared to the underlying economic profitability of a business. Given conservative accounting, higher growth tended to depress ROI, a decline that was accentuated by more conservative accounting rules. On the other hand, more conservative accounting increased ROI only if the rate of past growth in new investments was below some critical value, with the opposite effect emerging for growth rates above that critical value. To test the theoretical predictions of the model, the researchers used a data sample of 43,680 firm-year observations from 1982 to 2002.

The result is a tool for “decoding the economic profitability of a firm given the accounting profitability reported in the ROI number,” Reichelstein said. Contrary to earlier examples and numerical illustrations in textbooks and the relevant literature, “we now have a much more systematic grasp of the linkage between accounting and economic return.”

Both investors and managers can use the tool, “From a management perspective, it’s perfectly possible that one of your divisions has an ROI of 15 percent while another one has an ROI of 10 percent,” Reichelstein said. “You shouldn’t jump to the conclusion that the one giving you 15 percent is the one that’s adding more value to the business.” By applying the model, taking into account how rapidly both divisions have been growing and which has assets that may be more subject to a conservatism, management can more accurately determine the real economic profitability of both business groups.

The research, which earned best paper awards when presented at two international accounting conferences, is published as “Conser-vatism, Growth, and Return on Investment,” in the September 2006 issue of the Journal of Accounting, Auditing, and Finance.

—Lyn Denend