Aswath Damodaran 248
From Project ROE to Firm ROE
! As with the earlier analysis, where we used return on capital and cost of
capital to measure the overall quality of projects at Disney, we can compute
return on equity and cost of equity at Aracruz to pass judgment on whether
Aracruz is creating value to its equity investors
! In 2003 Aracruz had net income of 428 million BR on book value of equity of
6 , 385 million BR, yielding a return on equity of:
ROE = 428 / 6 , 385 = 6. 70 % (Real because book value is inflation adjusted)
Cost of Equity = 10. 79 %
Excess Return = 6. 70 % - 10. 79 % = - 4. 09 %
! This can be converted into a dollar value by multiplying by the book value of
equity, to yield a equity economic value added
Equity EVA = ( 6. 70 % - 10. 79 %) ( 6 , 385 Million) = - 261 Million BR
Here, we generalize to looking at the performance of the portfolio of projects
that a firm has. We use
The total net income of the firm as a measure of the equity earnings
generated by existing projects
The book value of equity as a measure of the equity invested in projects
in place
We cannot use market value of equity since it has embedded in it a premium for
expected future growth. Dividing current net income by market value of equity
will yield very low returns on equity for high growth firms, not because they
have necessarily taken bad projects.
We are assuming that the inflation accounting completely adjusts the book value
of equity for inflation, giving us real returns on equity. To the extent that this is
not true, the return can be biased. We are also using the cost of equity for the
entire firm (including cash) since the net income includes the interest income
from cash.
