So how and why do we use returns in our analysis and valuation? Remember that returns help us to assess how much profit the company is generating from its capital base. This information is relevant in two areas of our analysis.

Firstly, it helps us to appraise the historical performance of the business. If a company has historically generated higher or lower returns than competitors, this helps us to assess the quality of management and their investment decisions. One of the key decisions that management make is on capital allocation. That is how much capital to reinvest in the business and how that capital is deployed within the business. If historical returns were higher or lower than competitors. This helps us to assess whether the decisions that management made and the execution of those decisions created value for investors. Secondly, historical returns information helps us to make predictions about future returns and therefore future earnings. If a company is currently generating a return on capital of 10% and the company decides to scale up this business by investing 200 of new capital, then at a minimum we would expect 20 of additional earnings to be generated from this new capital. The more that we can use return on capital to explore the link between earnings growth and investment of new capital in our predictions, the more robust our forecasts will be.