Steve Alexander

Why Return on Capital Is So Important to Investors

> 1) In your invested capital formula, what's the intuition behind
> using those particular accounts? It seems more intuitive to me to
> define "invested capital" as net debt + equity. More explanation
> on your invested capital formula would be great.

The idea is to count "invested capital" as the net assets that are employed in generating profits. Lots of good companies have huge cash wads that are not employed in core profit generating activities. If you include these extra assets, your return on capital figure will be unduly low.

> 2) Also in your invested capital formula, you have (Short-term Liabilities
> + Interest Bearing ST Liabilities). But Interest Bearing ST Liabilities
> are already in Short-term Liabilities, so aren't you double counting
> here?

No, it removes Interest Bearing ST Liabilities from the equation. I would be double counting if it was (Short-term Liabilities - Interest Bearing ST Liabilities).

Why Return on Capital Is So Important to Investors

On Apr 16 04:47 AM ArtfulDodger wrote:

> Steve Alexander:
>
> This is a good article with good points. Thanks.
>
> These calculations certainly help to quantify a stock. Do they provide
> you with enough info to buy?
>
> Would you buy without qualifying the company? I.e., how well management
> works, how well the company markets, the quality of its products,
> competition, etc.
>

ROC is one point to look for when qualifying an investment, not the only point. Like Buffett says, a great business does not always make a great investment if it's priced too high. I always do a management and competitive analysis before recommending a stock. The Magic Formula strategy itself helps with price, as it only filters out stocks with a high operating earnings to enterprise value ratio (earnings yield).

Thanks for the comments everyone!