Many companies have changed their performance measures in recent years from measures of profit and margin to measures of return. This is intended to increase the focus of management on asset utilization that is implicitly expected to benefit shareholders.
There are many measures of return. They include return on equity (ROE), return on assets (ROA), return on invested capital (ROIC) and cash flow return on investment (CFROI). Another commonly used return measure is return on capital (ROC) which is formally defined as after-tax operating profit divided by invested capital. (Invested capital is defined as debt capital plus equity capital less cash.)
In practice, when defining ROC for internal business management, many companies replace “invested capital” with “net assets.” (Net assets are defined as operating assets less non-debt liabilities.) In most cases, net assets are numerically about the same as invested capital. Companies use the term net assets so their managers can directly see how to improve the measure by better managing the utilization of assets.
As part of our research, we have developed a return measure that uses gross operating assets as the denominator in calculating ROC. That correlates better with the way companies are valued in the stock market. Gross operating assets excludes cash, goodwill and intangibles. It includes accumulated depreciation, capitalized operating leases, capitalized research and development and non-interest bearing liabilities.
Within companies, managers can better utilize assets by, for example, being more efficient in their use of property, plant and equipment, faster in collecting accounts receivable, and more streamlined in the management of inventory stockpiles. But does asset utilization really matter to shareholders?
We studied asset utilization using a measure known as “asset intensity” for the 1000 non-financial U.S. companies with the largest market caps and compared that to total shareholder return (TSR) which includes capital gains and dividends. Asset intensity is calculated by dividing a company’s gross operating assets (as we’ve defined them above) divided by revenue. Simply put, better asset utilization yields lower asset intensity.
We also studied the relationship between three-year average asset utilization and three-year cumulative TSR. For all three-year rolling periods between 2005 and 2013, companies with above average asset utilization delivered average TSR of 2.2 percent more per year than those with below average asset utilization. That is a modest improvement, but not too statistically significant.
Why isn’t there more benefit to shareholders in companies having high asset utilization? Different companies and industries have dissimilar business models. Often, the companies with lower asset utilization generate higher profit margins, so they can often deliver adequate returns despite the lower asset utilization. So multi-business companies should recognize that its OK to have businesses that employ many assets at low utilization as long as they deliver enough margin to produce adequate returns.
The more important finding of our research involved the change in asset utilization. Whether asset utilization is low or high on average, companies that improved asset utilization across the same rolling three-year periods delivered an average of 7.6 percent more TSR per year than those with declining asset utilization.
Consider the Car
Consider the automobile & components industry. The companies with above- and below-average asset utilization produce about the same average TSR. If instead we divide the companies based on change in asset utilization we find those with improving asset utilization delivered 15.0 percent higher average TSR than those with worsening asset utilization. In every rolling three-year period those with improving asset utilization delivered higher TSR than those with declining asset utilization.
In our research we divided the “largest 1000 non-financial U.S. company” list into 20 industries. Asset utilization improvements related to better TSR over every rolling three-year period in most industries, including automobiles and components; consumer durables; energy, food and staples retailing; food, beverage and tobacco; health-care equipment; personal products; materials; life sciences; retailing; semiconductors; and software. Capital goods, technology hardware, media, consumer services, telecommunications, and transportation all showed similar indications, but with mixed results over one or two of the seven rolling periods.
The results were inconclusive in the commercial and professional services industry. That may be because the industry as a whole is quite “asset lite,” and the effects of changes in asset utilization are small in comparison to other company differences.
Potentially the most interesting finding, from a public policy perspective, concerns the utility industry: utilities with declining asset utilization, or increasing asset intensity, delivered better TSR in five of the seven rolling periods. Such companies are typically regulated based on achieving target rates of return. Thus, as long as they can convince regulators they need to invest capital, they are allowed to raise rates for electricity and gas if such increases are needed to make sure they earn the target return on that capital. Are we rewarding asset inefficiency? Are there better regulatory mechanisms?
Improving asset utilization does matter. Across the majority of industries where improving asset utilization relates to higher TSR, companies should be focused more on returns and less on profit and profit margins. The increasingly common focus on return measures will lead to improved asset utilization. And our research findings show this is typically beneficial for shareholders.
Gregory V. Milano, a regular CFO columnist, is the co-founder and chief executive officer and Allison Cavasino is an associate of Fortuna Advisors LLC, a value-based strategic advisory firm. Copyright © 2014 Fortuna Advisors LLC. All rights reserved.