Untitled book chapter on new empirical research methodologies on the business value of
information technologies and systems in Economics, Information Systems and Electronic
Commerce Research II: Advanced Empirical Methodologies. Edited by Robert J. Kauffman and
Paul P. Tallon, Associate Editor: Alina Chircu
Bruce Dehning
Argyros School of Business and Economics
Chapman University
Orange, CA 92866
Phone: (714) 628-2702; Fax: (714) 532-6081
Email: bdehning@chapman.edu
Vernon J. Richardson
School of Business
University of Kansas
Lawrence, KS 66045-2003
Phone: (785) 864-7507; Fax: (785) 864-5328
Email: vrichardson@ku.edu
Robert W. Zmud
Michael F. Price College of Business
University of Oklahoma
Norman, OK 73019
Phone: (405) 325-0791; Fax: (405) 325-7482
Email: rzmud@ou.edu
1
Here is an outline and suggested development of the paper: IT affects firm performance as
measured by ROE. ROE decomposition and the value chain can be used to show where IT
affects the firm. We relate firm performance to firm value through the residual income model,
which shows firm value can be expressed as book value, ROE, and the cost of equity capital
(risk).
First we start with Figure 1 from Dehning and Richardson 2002. This shows that IT has
direct and indirect effects on businesses process, which collectively determine overall firm
performance. Then we add Porter’s Value Chain and the determinants of market value to arrive
at Figure 2. Figure 2 shows that firm performance, financial leverage, and risk collectively
determine firm value. IT affects firm performance and risk, and can affect financial leverage.
The key is linking financial performance variables to both the value chain and firm value,
and this is done with the Residual Income Model (RIM) (Edwards and Bell 1961, Feltham and
Ohlson 1995, Ohlson 1995, Peasnell 1982) and ROE decomposition. The RIM shows that a
company’s value will be equal to its book value unless it can produce residual income. As
shown in equation (1), this model denotes stock price as a firm’s current book value, plus the
discounted sum of all future residual income.1 Residual income includes a charge for the capital
employed in the business in addition to materials and labor, so it is a better measure of the true
operating performance of the company.
V0  BV0 
I1  (re  BV0 ) I 2  (re  BV1 ) I 3  (re  BV2 )


 ...
1  re
(1  re ) 2
(1  re )3
(1)
Where:
V0 =
BV =
re =
I=
I t  re * BVt 1 =
Current firm value.
Book value of the firm.
The cost of equity capital.
Net Income.
Residual Income.
1
The RIM assumes a clean surplus relation. This requires that except for transactions with owners, changes in book
value (BV) are due to earnings (I) and dividends (D): BV1  BV 0  I 1  D1 . This is the concept behind
comprehensive income in the United States Generally Accepted Accounting Principles (GAAP).
2
This can be re-written as

V0  BV 0   (1  re ) t [ I t  (re  BV t 1 )]
(2)
t 1
It is possible to express residual income in terms of ROE2 because
I t  (re  BVt 1 )  ( ROE t  re )  BVt 1
(3)
Thus equation (2) can be rewritten entirely in terms of ROE and book value, as shown in
equation 4.
V0  BV 0 
ROE 1  re   BV0 ROE 2  re   BV1 ROE 3  re   BV 2


1  re 
1  re 2
1  re 3
 ...
(4)
That is equivalent to

V0  BV 0   (1  re ) t [( ROE t  re )  BV t 1 )]
(5)
t 1
Now that we have shown that firm value can be expressed in terms of accounting ratios, we can
decompose ROE into component parts representing profitability, turnover, and leverage (Halsey
2001):
ROE  NOPAT Margin  Operating Asset Turnover  Spread  Leverage
(6)
 NOPAT
Net Interest  Net Debt
Sales   NOPAT
  

ROE  


Net Assets   Net Assets
Net Debt  Equity
 Sales
(7)
Or
Where:
ROE =
NOPAT =
Sales =
Net Assets =
Net Interest =
Net Debt =
Equity =
2
Net Income / Shareholder’s Equity
Net Operating Profit After Taxes = Net Income + Net Interest
Total Net Sales
Total Noncurrent Assets minus Non-interest Bearing Noncurrent
Liabilities
(Interest Expense - Interest Income)  (1 - Tax Rate)
Total Interest Bearing Liabilities - Cash and Marketable Securities
Total Stockholder’s Equity (Book Value)
Note that ROE here is calculated using beginning shareholder’s equity.
3
The profitability and turnover portions of the decomposition will be further decomposed into
their component parts and placed into the context of Porter’s Value Chain (shown in Figure 3).
Each ratio will measure an area of the value chain: inbound processes, operations, outbound
processes, and support activities, as shown in Table 1.
To empirically demonstrate the model we use the firms that successfully implemented IT
from the Dehning, Richardson, and Zmud 2003 dataset. Using those firms that had an increase
in ROE from implementing IT, we calculate all performance measures and market measures
necessary to demonstrate the model shown in the bottom half of Figure 2. We can also include
some contextual factors to show how those impact the firm’s ability to use IT for increasing firm
performance and firm value.
4
Impact of IT on the Firm
Direct Effects
Information
Technology
Indirect Effects
Firm
Performance
Business
Processes
As Measured by Researchers
1
Information
Technology
Measures:
1. Spending
2. Strategy
3. Management
or Capability
2
Process Measures
e.g. Gross Margin,
Inventory Turnover,
Customer Service,
Quality, Efficiency
3
Firm Performance Measures:
A. Market
e.g. Event Study,
Association Study,
Tobin's q, Market Value
B. Accounting
e.g. ROA, ROE, ROS
Market Share
4
Contextual Factors
e.g. Industry, Size,
Financial Health, IT
Intensity
5
Figure 1
From Dehning and Richardson 2002
5
Impact of IT on the Firm
Profitability
Information
Technology
Direct Effects &
Efficiency
Indirect Effects
Leverage
Firm
Value
Risk
Empirical Framework
Value Chain
Measures:
Profitability
Information
Technology
Overall Firm
Performance:
ROE
Decomposition Profitability,
Efficiency,
Leverage
Value Chain
Measures:
Efficiency
Contextual
Factors
Firm Value
Risk
Figure 2
Empirical Framework for Measuring the Business Value of Information Technologies and Systems
6
Inbound
Processes
Operations
Outbound
Processes
Overall
Performance
Support Activities: Technology Development, Human
Resource Management, Firm Infrastructure
Figure 3
The value chain model.
7
Figure 4
Value Chain Profitability Ratios
Inbound Logistics and
Procurement

Operations
Gross Margin
Outbound Logistics,
Marketing, Sales, and
Service


Market Share
Bad Debt Expense
as a % of Sales

Overall
Performance

Net Profit Margin
Support Activities
Technology Development, Human Resource Management, Firm Infrastructure

Selling, General, and Administrative Expenses
8
Figure 5
Value Chain Efficiency Ratios
Inbound Logistics and
Procurement


Raw Materials
Inventory
Turnover
Accounts Payable
Turnover
Operations




Operating Asset
Turnover
Net Long-Term
Asset Turnover
PP&E Turnover
Work-in-Process
Inventory
Turnover
Outbound Logistics,
Marketing, Sales, and
Service
 Finished Goods
Inventory
Turnover
 Operating
Working Capital
Turnover
 Accounts
Receivable
Turnover
Overall
Performance

Total Asset Turnover
Support Activities
Technology Development, Human Resource Management, Firm Infrastructure
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Table 1
Overall Performance and Leverage Measures
Measure
Overall Performance
ROE
Operating ROA
Leverage and Risk
Spread
Leverage
Effective Interest Rate After Taxes
Debt to Equity
Net Debt to Equity
Debt to Capital
Net Debt to Net Capital
Interest Coverage (Earnings Based)
Interest Coverage (Cash Based)
Current Ratio
Quick Ratio
Operating Cash Flow Ratio
Beta
Table 2
Ratio Formulas
Measure
Overall Performance
ROE
Operating ROA
Definition
NI / SE
NOPAT / Net Assets
Components of the Value Chain
Inbound Processes
Gross Margin
Raw Materials Inventory Turnover
Accounts Payable Turnover
Operations
Operating Asset Turnover
Net Long-Term Asset Turnover
PP&E Turnover
Work-in-Process Inventory Turnover
(Sales - Cost of Goods Sold) / Sales
Cost of Goods Sold / Raw Materials Inventory
Purchases / AP
Sales / Net Assets
Sales / Net Long-Term Assets
Sales / Net PP&E
Cost of Goods Sold / Work-in-Process
Inventory
Outbound Processes
10
Market Share
Finished Goods Inventory Turnover
Operating Working Capital Turnover
Accounts Receivable Turnover
Bad Debt Expense as a % of Sales
Sales / Total Industry Sales
Cost of Goods Sold / Finished Goods
Inventory Turnover
Sales / Operating Working Capital
Sales / AR
Bad Debt Exp / Sales
Support Activities
Selling, General, and Administrative Expenses
Selling, General, and Administrative Expenses / Sales
Other Ratios
NOPAT Margin
EBITDA
EBITDA Margin
Quality of Income
Inventory Turnover
NOPAT / Sales
NI + Int + Taxes + Depr + Amort
EBITDA / Sales
CFO / NI
CoGS / Inventory
Leverage and Risk
Spread
Leverage
Effective Interest Rate After Taxes
Debt to Equity
Net Debt to Equity
Debt to Capital
Net Debt to Net Capital
Interest Coverage (Earnings Based)
Interest Coverage (Cash Based)
Current Ratio
Quick Ratio
Operating Cash Flow Ratio
Beta
Operating ROA - Effective Interest Rate After
Tax
Net Debt / Equity
NIAT / Net Debt
(Short-Term Debt + Long-Term Debt) / SE
(Short-Term Debt + Long-Term Debt - Cash
& MS) / SE
(Short-Term Debt + Long-Term Debt) /
(Short-Term Debt + Long-Term Debt + SE)
(Int Bearing Liab. - Cash & MS) /
(Int Bearing Liab. - Cash & MS + SE)
(NI + Int Exp + Taxes) / Int Exp
(CFO + Int + Taxes) / Int [use cash amounts]
Current Assets / Current Liabilities
Quick Assets / Current Liabilities
CFO / Current Liabilities
Cov( R A , R M )
A 
2
M
11
References
Dehning, B., and Richardson, V.J. “Returns on investments in information technology: A
research synthesis.” Journal of Information Systems, Vol. 16, Num. 1, Spring 2002, pp.
7-30.
Dehning, B., Richardson, V.J. and Zmud, R.W. “The Value Relevance of Announcements of
Transformational Information Technology Investments,” MIS Quarterly, 27, 4, 2003, pp.
637-656.
Halsey, R. “Using the Residual-Income Stock Price Valuation Model to Teach and Learn ratio
Analysis,” Issues in Accounting Education, Vol. 16, No. 2, May 2001, pp. 257-272.
Porter, M.E. Competitive Advantage. New York: The Free Press, 1985.
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