Contents
Average returns are a critical metric for businesses seeking sustainable growth and profitability. Understanding average returns provides valuable insights into a company’s competitive position within its industry. We explore the concept of average returns in this article, focusing on its relationship to competitive advantage rather than investment returns. We will delve into what average returns are, why they matter, and how they can be calculated.
Understanding average returns
Average returns measure a company’s profitability relative to the capital it employs. In simpler terms, it indicates how efficiently a business generates profits from its invested funds. To calculate average returns, specifically return on invested capital (ROIC), divide a company’s net income (or net operating profit after tax) by its invested capital, which comprises equity and debt.
Average returns are crucial for businesses aspiring to outperform their competitors. A company generating returns above the industry average often possesses a competitive advantage, a strategic edge that enables it to create superior value for its customers. Conversely, businesses delivering below-average returns may face challenges in attracting investors, sustaining growth, and maintaining market share.
Why average returns matter
Average returns serve as a crucial indicator of a company’s competitive advantage. Sustained profitability above industry averages signifies a company’s ability to outperform competitors and create value. Conversely, persistent below-average returns signal potential challenges, including investor dissatisfaction, limited growth prospects, and even the risk of business failure.
Investors closely monitor a company’s average returns when considering investment opportunities. High average returns attract capital, enabling businesses to fund expansion, research and development, and other growth initiatives. Conversely, low average returns can deter investors, making capital acquisition more expensive and potentially limiting growth opportunities.
The influence of industry competition on average returns
Average returns vary significantly across industries. The intensity of competition within an industry is a primary determinant of these variations.
Porter’s Five Forces model offers a robust framework for analyzing the competitive landscape and its impact on average returns. This influential model identifies five key forces that shape industry competition and ultimately influence the average returns achievable within an industry. These forces include:
- Barriers to entry are obstacles that hinder new competitors from entering the market. These barriers can range from high capital requirements and economies of scale to government regulations and strong brand loyalty.
- Threat of substitution is the likelihood of customers opting for alternative products or services. This force assesses the availability of substitutes and their potential impact on industry profitability.
- Bargaining power of buyers refers to the influence customers have on pricing and terms. Powerful buyers can exert downward pressure on prices, reduce profit margins, and demand additional services or concessions.
- Bargaining power of suppliers refers to the impact suppliers have on input costs. Suppliers with strong bargaining power can increase the cost of raw materials, components, or other inputs, thereby reducing industry profitability.
- Rivalry among existing competitors is the intensity of competition within the industry. Factors such as the number of competitors, industry growth rate, and product differentiation influence the level of rivalry and its impact on average returns.
These forces collectively shape the competitive landscape and ultimately influence the average returns achievable within an industry.
Building a competitive advantage
Achieving and sustaining above-average returns requires a well-defined competitive advantage. This advantage stems from a company’s core competencies—unique capabilities and resources that are valuable, rare, and difficult for competitors to imitate.
To leverage core competencies and achieve superior performance, companies typically adopt one of two primary competitive strategies:
- Cost leadership: This strategy emphasizes efficiency and economies of scale to offer products or services at the lowest cost within the industry. Companies pursuing a cost leadership strategy often target a broad market to maximize sales volume and profitability.
- Differentiation: This strategy focuses on creating products or services that are perceived as unique and superior by customers. By offering distinct value propositions, companies can charge premium prices. Differentiation strategies can be applied to both broad and niche markets.
Target market selection is crucial for the success of any competitive strategy. A broad market encompasses a large customer base, potentially offering significant growth opportunities. However, intense competition is often associated with broad markets. Conversely, niche markets focus on specific customer segments with specialized needs. While smaller in size, niche markets may offer less competition and higher profit margins.
By carefully selecting a target market and implementing an appropriate competitive strategy, companies can enhance their chances of building and sustaining a competitive advantage, which can ultimately lead to superior financial performance.
Calculating average returns: a practical guide
Understanding how to calculate average returns is crucial for evaluating a company’s financial performance within its industry. One key metric for assessing it is the Return on Invested Capital (ROIC). By calculating ROIC, analysts can gain valuable insights into a company’s efficiency in generating returns from its capital resources. This metric serves as a powerful tool for comparing a company’s performance to industry benchmarks and identifying opportunities for improvement in capital allocation.
- ROIC = NOPAT / Invested Capital = NOPAT / (Debt + Equity)
Here’s how to calculate ROIC:
- Determine Net Operating Profit After Tax (NOPAT): This figure represents the company’s operating profit after accounting for taxes. It excludes interest expenses as we want to evaluate the profitability of the core operations.
- Calculate Invested Capital: Sum the company’s equity and debt, including both long-term and short-term components. This represents the total capital employed in the business.
- Divide NOPAT by Invested Capital: The resulting quotient is the company’s ROIC. It indicates the return generated for each dollar of capital invested.
Consider five companies in the food industry with the following ROICs over the past decade: 12%, 13%, 10%, 8%, and 7%. By summing these values and dividing by five, we calculate the industry’s average ROIC as 10%.
Remember: Net Operating Profit After Tax (NOPAT) represents a company’s operating profit after accounting for taxes but before deducting interest expenses. By isolating operating performance, NOPAT provides a clearer picture of a company’s core profitability. While NOPAT is ideal for analysis, net income can be used as a proxy if specific data is unavailable or if a quick estimate is needed. However, it’s important to note that net income includes the impact of financing decisions, which can distort comparisons between companies with different capital structures.
Interpreting the Results
Companies exhibiting ROICs above the industry average are likely to possess a competitive advantage. However, it’s crucial to conduct further analysis to confirm this advantage. Factors such as the company’s business model, industry dynamics, and economic conditions can influence profitability.
By comparing a company’s ROIC to its industry benchmark and historical performance, investors and analysts can gain valuable insights into its financial health and competitive position.
While calculating average returns provides a foundational understanding, a comprehensive analysis requires considering additional factors such as revenue growth, profit margins, and asset turnover. These metrics offer a more holistic view of a company’s financial performance and its ability to generate sustainable returns.
Wrapping up
Average returns serve as a critical barometer of a company’s financial health and competitive standing. By understanding how to calculate, interpret, and leverage it, businesses can make informed decisions to enhance profitability and long-term success.
A strong correlation exists between average returns and a company’s competitive advantage. Consistently generating returns above the industry average often signals a company’s ability to create superior value for its customers and shareholders. Conversely, below-average returns may indicate challenges in areas such as cost efficiency, innovation, or market positioning.
Remember, average returns are just one piece of the financial puzzle. Combining this metric with other key performance indicators provides a more comprehensive understanding of a company’s overall performance.
