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Economic profitability and the accounting rate of return

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  • Carlo Alberto Magni

    ()

  • Ken Peasnell

    ()

Abstract

The internal rate of return (IRR) is a widely used benchmark for assessing the reliability of the accounting rate of return (ROA) as a measure of economic profitability. We turn this reasoning process on its head by demonstrating that a suitable (weighted average) aggregation of ROAs better captures what is generally meant by economic profitability than does the IRR. We show that average ROA when compared with the cost of capital, will always correctly signal economic profitability in the sense that it will correspond exactly with what would be obtained from a net present value calculation. We also show that average ROA can be used to make meaningful inter-firm comparisons of profitability, when due allowance is made for differences in investment scale. Using this framework, we show how average ROA can be used to assess economic profitability for a truncated time series where the opening and closing capital stocks provided by the accounting system do not adequately represent the firm´s initial and ending endowments of resources. Finally, we suggest how this approach can be put to practical use in assessing profitability of firms on an on-going basis.

Suggested Citation

  • Carlo Alberto Magni & Ken Peasnell, 2012. "Economic profitability and the accounting rate of return," PROYECCIONES FINANCIERAS Y VALORACION 009400, MASTER CONSULTORES.
  • Handle: RePEc:col:000463:009400
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    File URL: http://papers.ssrn.com/abstract=2027607
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    References listed on IDEAS

    as
    1. Magni, Carlo Alberto, 2005. "On decomposing net final values: EVA, SVA, and shadow project," MPRA Paper 12357, University Library of Munich, Germany.
    2. Carlo Magni, 2005. "On Decomposing Net Final Values: Eva, Sva and Shadow Project," Theory and Decision, Springer, pages 51-95.
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    More about this item

    Keywords

    Economic profitability; internal rate of return; accounting rate of return;

    JEL classification:

    • M4 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting
    • G00 - Financial Economics - - General - - - General

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