Why Return on Capital Is So Important to Investors

 |  Includes: DLX, INTC, MRK, PFE
by: MagicDiligence

As adherents to Joel Greenblatt's Magic Formula Investing strategy know, the formula boils investing down to two simple statistics: Earnings yield and return on capital. Earnings yield is a measure of how cheap a company is against its profits. Return on capital is a measure of how efficiently a company employs its resources to generate those profits. When you put them together, they are the tangible statistics behind the simple strategy of buying good businesses (high return on capital) at low prices (high earnings yield).

In this article, we will dive more into the return on capital figure and examine its importance and how it is calculated.

So, what exactly does return on capital tell us? For most investors, an analogy may be the most apt way to grasp the meaning. Imagine you are an investor shopping for a mutual fund in which to park your money. Since you are investing for the long term, you leaf through prospectuses looking at the 10-year average return. Fund manager A has managed to deliver 15% annual gains to his investors, while fund manager B has delivered just 5%. Clearly, your money would have grown faster by being with fund manager A, as he would have better allocated your dollars to achieve wealth.

The concept is no different in business. Management has to decide how to allocate their capital, including equity capital (earned through the issuance of shares to the public), debt capital (acquired through bond issuance or bank loans), and operating earnings (earned through operations). The decision has to be made - do I spend to grow sales organically, for example by spending on product development or new sales territories? Or do I pay to acquire new business lines? Or are growth opportunities limited and acquisitions overpriced enough that I should just sit on my cash or pay it back to shareholders? These decisions are at the core of senior management, and the effectiveness of these decisions are reflected in the return on capital number. A business with a higher return on capital, like a mutual fund with a great manager, will deliver more wealth to its shareholders over the long term.

So, how is it calculated? First, there are several ways to measure it. The simplest and most widely available are return on assets (ROA) and return on equity (ROE). The return on assets equation measures the profit earned on each dollar of raw assets (buildings, cash, equipment, inventory, and so forth). The calculation here is:

Return on assets = Net Income / Total Assets

Return on equity is the profit earned on each dollar of equity capital - in essence, each dollar you own of the company. This is a bit more meaningful because it takes a firm's liabilities and debt into account and gives a better estimate of what net capital actually is. The calculation here:

Return on equity = Net Income / Total Equity

There are problems with each of these measures, however. Return on assets is a useful equation for comparing firms within the same industry; for example, comparing Pfizer (NYSE:PFE) against Merck (NYSE:MRK). However, it is usually not useful for comparing firms in different industries with different capital requirements, and it also does not take into account what assets are actually employed in generating profits and which are "extra". Return on equity, on the other hand, is somewhat better as it does subtract out liabilities. However, it can present a skewed picture for firms with a lot of debt. For example, check printer Deluxe (NYSE:DLX) has a return on equity that looks outstanding at 175%, until you realize that the company has a nearly $900 million debt load, leaving just $65 million in equity!

Return on capital solves these problems. It counts only assets and liabilities that are employed in generating operating earnings, and removes the rest. Non-operating costs and profits, such as interest and equity investments, are removed to get a more clear picture of the business itself. The equation for calculating traditional invested capital is:

Return on Invested Capital (ROIC) = (Operating Earnings * (1 - Tax Rate)) / Invested Capital

Invested Capital = (Total Assets - Excess Cash - Interest Bearing Assets) - (Short-term Liabilities + Interest Bearing ST Liabilities)

I've talked about some of these figures before, such as excess cash which is described here. To illustrate an ROIC calculation, we'll use a previous example, Intel (NASDAQ:INTC). See here for the full balance sheet figures from which this calculation is derived.

Total Assets = 55,651

Excess Cash = 12,797

Interest Bearing Assets = 987 (Equity Securities) + 4,398 (Other LT Investments) = 5,385

Short-term Liabilities = 8,571

Interest Bearing ST Liabilities = 142 (Short-term debt)

Invested Capital = (55,651 - 12,797 - 5,385) - (8,571 + 142) = 28,898

Intel (INTC) earned $8.732 billion in operating earnings, and paid a tax rate of about 23.9%. Therefore, ROIC would be:

ROIC = (8,732 * (1 - 0.239)) / 28,898 = 0.230 or 23%

Clearly, 23% is a very good return on capital. Most investors would be quite pleased with an investment that earned that kind of return annually!

Now, the Magic Formula strategy as devised by Greenblatt uses a slightly different calculation. First, it differs in calculating Invested Capital. Difficult to value assets like goodwill (the amount paid over book value for acquisitions) and intangible assets (like brands, patents, and so on) are removed, as different companies may use different accounting assumptions for these. Also, the tax rate is removed from the ROIC calculation, as some industries have the ability to manufacture favorable tax conditions. By removing them, a more comparable figure is created, although the actual meaning of that figure is somewhat diminished. In practice, an MFI return on capital figure north of 40% is pretty good. When looking for Top Buy picks, MagicDiligence uses both numbers to find the truly great companies. So, for Intel, calculating MFI invested capital looks like this:

MFI Invested Capital = Invested Capital - Goodwill - Intangible Assets

= 28,898 - 3,916 (Goodwill) = 24,982

MFI ROIC = Operating Earnings / MFI Invested Capital

= 8,732 / 24,982 = 34.9%

35% Magic Formula return on capital is good, but not outstanding. However, the fact that Intel's traditional ROIC is so high is additional evidence that it is an exceptional business. For it to be a Magic Formula stock, the earnings yield hurdle would be set higher. Also, Intel has been able to maintain high returns on capital over a long period of time, evidence of a competitive moat.

Return on capital is a most important measure of the efficiency of a business and should be an important tool for stock investors, Magic Formula or otherwise.

Disclosure: Steve owns INTC, PFE