A Simulation Assessment of Three Methods for Deriving the Long-run Profitability of the Firm as its Internal Rate of Return

Timo Salmi and Ilkka Virtanen

Abstract

Three long-term profitability estimation methods, Kay's, Ijiri's and the average accountant's rate of return method are evaluated using simulated financial statements. It is observed that the methods are disrupted by large deviations between growth and profitability, but are insensitive to cyclical fluctuations. The numerical performance of the methods is roughly at par, but Ijiri's method is more unpredictable than the theoretically better founded Kay's method. The average accountant's rate of return method fares almost as well as Kay's method, and can be recommended for financial analysis because it is based on well-established accounting practice.

Key words: Long-term profitability, accountant's rate of return, internal rate of return, IRR estimation models, simulation.

The Finnish Journal of Business Economics Vol. 46 (1997), No 3, 256- 281.