Understanding Return on Capital: The Key to Long-Term Investment Success

For long-term investors seeking to build wealth, understanding how efficiently a company uses its capital is crucial. Return on Capital metrics provide valuable insights into a company’s ability to generate profits from its investments. In this comprehensive guide, we’ll explore the importance of various Return on Capital measures—including Return on Invested Capital (ROIC), Return on Capital Employed (ROCE), Return on Equity (ROE), Return on Assets (ROA), and Free Cash Flow Return on Capital Employed (FCF ROCE)—and explain why focusing on companies with high returns on capital can significantly enhance your investment outcomes.

What is Return on Capital?

Return on Capital refers to a group of financial metrics that measure how effectively a company generates profits from its capital base. These metrics help investors assess management’s efficiency in allocating capital to profitable projects and can be used to compare companies within the same industry. A higher return on capital indicates that a company is using its funds more efficiently to generate earnings, which can lead to increased shareholder value over time.

Return on Invested Capital (ROIC) Explained

Return on Invested Capital (ROIC) is a critical metric that measures the return a company generates on the capital invested in its business operations. It provides a clear picture of how well a company is using its funds to generate profits. A higher ROIC indicates a more efficient company that can create value for shareholders.

ROIC is calculated using the formula:

ROIC = Net Operating Profit After Tax (NOPAT) / Invested Capital

• Net Operating Profit After Tax (NOPAT): This represents the company’s operating profits after taxes, excluding financing costs. It reflects the profits generated from core operations.
• Invested Capital: The total capital invested in the company’s operations, including debt and equity, minus non-operating assets like excess cash.

Why ROIC Matters

ROIC is favored by investors like Charlie Munger because it focuses on the efficiency of the core business operations, excluding the effects of financial leverage. As Charlie Munger once said:

“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”

This highlights the importance of investing in companies with high ROIC, as their ability to generate superior returns on capital often translates into strong shareholder returns. A company with a high ROIC can reinvest its earnings at a high rate of return, leading to exponential growth in earnings and, consequently, shareholder value over time.

Return on Capital Employed (ROCE) Explained

Return on Capital Employed (ROCE) assesses a company’s profitability and capital efficiency by comparing operating profit to capital employed. It measures how well a company is generating profits from its total capital employed.

ROCE is calculated using the formula:

ROCE = Earnings Before Interest and Tax (EBIT) / Capital Employed

• Earnings Before Interest and Tax (EBIT): Also known as operating profit, it represents the profit a company makes from its operations before deducting interest and taxes.
• Capital Employed: The total capital used for the acquisition of profits. It is calculated as Total Assets minus Current Liabilities.

Why Terry Smith Prefers ROCE

Terry Smith, a renowned fund manager and founder of Fundsmith, emphasizes the importance of ROCE in evaluating companies. He prefers ROCE because it provides a clear picture of how efficiently a company employs all its capital to generate earnings, not just equity. Smith argues that investing in companies with high ROCE is akin to choosing a bank account with the highest interest rate—you naturally prefer to invest where your capital earns the most.

According to Terry Smith, focusing on companies with high and sustainable ROCE can lead to superior investment returns over the long term. High ROCE indicates that a company can generate more profits per unit of capital employed, leading to greater value creation for shareholders over time.

Return on Equity (ROE) and Return on Assets (ROA)

While ROIC and ROCE are valuable metrics, it’s important to understand other return measures like Return on Equity (ROE) and Return on Assets (ROA) and their limitations.

Return on Equity (ROE)

Return on Equity (ROE) measures how effectively a company uses shareholders’ equity to generate net income. It is calculated as:

ROE = Net Income / Shareholders’ Equity

While ROE can provide insights into a company’s profitability relative to shareholder investments, it has several limitations:

• Influenced by Leverage: High levels of debt can inflate ROE because shareholders’ equity is reduced while net income may not be proportionally affected. This can make a highly leveraged company appear more efficient than it actually is.
• Impact of Share Buybacks: Share buybacks reduce the number of outstanding shares and can decrease shareholders’ equity. This reduction can artificially inflate ROE without any real improvement in the company’s operational performance.
• Accounting Practices: ROE can be affected by accounting decisions that impact net income or equity, making comparisons across companies less reliable.

Return on Assets (ROA)

Return on Assets (ROA) measures how efficiently a company uses its assets to generate net income. It is calculated as:

ROA = Net Income / Total Assets

ROA provides an indication of how profitable a company is relative to its total assets. However, ROA has limitations:

• Industry Variations: ROA can vary widely across industries due to differences in asset intensity. Capital-intensive industries like utilities may have lower ROA compared to asset-light industries like software.
• Ignores Financial Structure: ROA does not consider how assets are financed (debt vs. equity), which can be important when assessing financial risk.
• Depreciation Policies: Different depreciation methods can affect the book value of assets, impacting ROA comparisons between companies.

Free Cash Flow Return on Capital Employed (FCF ROCE)

Free Cash Flow Return on Capital Employed (FCF ROCE) measures how efficiently a company generates free cash flow relative to its capital employed. It focuses on cash profitability rather than accounting profits.

FCF ROCE is calculated as:

FCF ROCE = Free Cash Flow / Capital Employed

Focusing on free cash flow provides a clearer picture of a company’s financial health, as it is less subject to accounting adjustments. Free cash flow represents the cash generated by the company’s operations after accounting for capital expenditures needed to maintain or expand its asset base.

We’ll explore free cash flow in more detail in a separate blog article, but it’s important to note that FCF ROCE can provide additional insights into a company’s cash-generating efficiency.

Comparing ROIC, ROCE, ROE, and ROA

While all these metrics measure returns relative to some form of capital or assets, they have distinct differences:

• ROIC: Focuses on returns generated from all invested capital (both debt and equity), providing a comprehensive view of operational efficiency. It excludes non-operating assets and emphasizes core business profitability.
• ROCE: Assesses profitability relative to capital employed (total assets minus current liabilities). It provides insight into how well a company utilizes all available capital to generate operating profits.
• ROE: Measures returns generated on shareholders’ equity but can be skewed by high debt levels, share buybacks, and accounting practices.
• ROA: Evaluates how efficiently a company uses its total assets to generate net income but does not consider the company’s financing structure.

Investors often prefer ROIC and ROCE over ROE and ROA because they provide a more comprehensive assessment of a company’s efficiency in using its capital base, accounting for both debt and equity, and focus on operational performance rather than financial leverage or accounting adjustments.

When ROIC and ROCE May Produce Different Results

Although ROIC and ROCE are similar, they can produce different results due to differences in their calculations:

• Definition of Capital:
  • ROIC: Uses Invested Capital, which typically excludes non-operating assets like excess cash and focuses on capital actively used in operations.
  • ROCE: Uses Capital Employed, generally calculated as Total Assets minus Current Liabilities, which may include all assets regardless of their operational use.
• Profit Measurement:
  • ROIC: Uses NOPAT, representing operating profit after taxes.
  • ROCE: Uses EBIT, which is pre-tax and before interest, providing a pre-tax return measure.
• Tax Considerations: Since ROIC is an after-tax measure and ROCE is a pre-tax measure, differences in tax rates can affect the metrics differently.

Investors should consider these differences when analyzing companies and choose the metric that best fits the context of their analysis.

High Return on Capital and Economic Moats

Companies with consistently high returns on capital often possess sustainable competitive advantages, or economic moats. An economic moat refers to a company’s ability to maintain its competitive edge over rivals, protecting its long-term profits and market share.

High ROIC and ROCE can indicate the presence of an economic moat, as the company can reinvest earnings at high rates of return, further strengthening its competitive position. As Warren Buffett famously said:

“The most important thing [is] trying to find a business with a wide and long-lasting moat around it… protecting a terrific economic castle.”

By identifying companies with high returns on capital and strong economic moats, investors can benefit from sustained growth and profitability over the long term. Characteristics of companies with economic moats include:

• Strong Brand Identity: Companies like Coca-Cola have established brands that command customer loyalty.
• Cost Advantages: Companies that can produce goods or services at a lower cost than competitors, such as Walmart.
• Network Effects: Platforms like Facebook become more valuable as more users join.
• Intangible Assets: Patents, trademarks, and proprietary technology provide competitive barriers, as seen with pharmaceutical companies.

Reinvesting Earnings and the Power of Compounding

When a company with a high return on capital reinvests its earnings back into the business, it can achieve exponential growth through the power of compounding. This means that each year’s earnings generate additional earnings in subsequent years, leading to accelerated growth over time.

Many investors underestimate the impact of compounding high returns over a long period. For example, a company generating a ROIC of 20% and consistently reinvesting its earnings can double its invested capital and earnings approximately every four years. Over a decade or more, this compounding effect can lead to significant increases in shareholder value.

As Albert Einstein reportedly said:

“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

Companies capable of consistently reinvesting at high ROIC can justify higher price-to-earnings (P/E) ratios because their future earnings are expected to grow rapidly. This aligns with Buffett’s investment philosophy:

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

By paying a reasonable price for a high-quality company with strong returns on capital, investors can benefit from the compounding effect of reinvested earnings over the long term.

Industries with High and Low Returns on Capital

Returns on capital can vary significantly across different industries due to structural factors and competitive dynamics.

Industries with High Returns on Capital

• Technology: Companies with scalable business models and low incremental costs, such as software firms like Microsoft and Adobe, often have high ROIC and ROCE.
• Consumer Goods: Brands with strong customer loyalty and pricing power, such as Nestlé and Procter & Gamble, can maintain high returns.
• Healthcare: Pharmaceutical and medical device companies with patented products, like Johnson & Johnson, may enjoy high returns due to barriers to entry.
• Services: Professional services firms with asset-light models, such as Accenture, often exhibit high returns on capital.

Industries with Low Returns on Capital

• Utilities: High capital requirements and regulated pricing can limit returns. Companies like electric utilities often have lower ROIC and ROCE.
• Telecommunications: Intense competition and significant infrastructure costs may reduce profitability for companies like AT&T and Vodafone.
• Airlines: High operating costs, cyclical demand, and price competition often result in lower returns. Warren Buffett famously referred to the airline industry as a “death trap” for investors.
• Commodities: Companies in oil, gas, and mining are subject to volatile commodity prices and high capital expenditures, often leading to lower returns on capital.

Investors seeking companies with high returns on capital should focus on industries where sustainable competitive advantages are more prevalent and where companies can maintain pricing power and profitability over time.

How High Returns on Capital Benefit Shareholders

Understanding how high returns on capital translate into shareholder value is essential:

• Increased Earnings: Efficient use of capital leads to higher profits, which can be reinvested or distributed as dividends.
• Reinvestment Opportunities: Companies that can reinvest earnings at high returns can compound growth, increasing the intrinsic value of the business.
• Share Price Appreciation: As earnings grow, the company’s stock price may increase, providing capital gains to shareholders.
• Dividend Growth: Higher profits can support increased dividend payments over time, providing income to investors.

By investing in companies that generate high returns on capital, shareholders can benefit from both income and capital appreciation, enhancing their overall investment returns. This approach aligns with a long-term investment strategy focused on wealth accumulation.

Leveraging Return on Capital Metrics with Stock Investor IQ

At Stock Investor IQ, we provide tools to help you identify companies with high returns on capital:

• Quality Stock Screener: Our Quality Stock Screener focuses on ROCE, allowing you to filter companies based on this important metric. Identify high-quality companies that efficiently use their capital.
• Other Stock Screeners: ROIC is used in all our other stock screeners, such as the Value Investing Stock Screener and the Growth Stock Screener, helping you find companies with strong operational efficiency.
• Stock Analysis Dashboard: Access detailed financial metrics, including return on capital measures, to evaluate investment opportunities.
• Stock Investing Glossary: Enhance your understanding of key financial terms and ratios.

By utilizing these resources, you can make informed investment decisions and build a portfolio of high-quality companies with strong returns on capital.

Conclusion

Return on Capital metrics like ROIC and ROCE are essential tools for investors seeking to identify companies that efficiently generate profits from their capital base. While all return metrics provide valuable insights, understanding their differences and limitations can help you select the most appropriate measures for your analysis. Focusing on companies with high returns on capital can lead to superior investment performance over the long term.

Remember the wisdom of legendary investors like Charlie Munger and Terry Smith, who emphasize the importance of investing in high-quality businesses with sustainable competitive advantages and strong returns on capital. By leveraging the power of compounding and focusing on companies that can reinvest at high rates of return, you position yourself for long-term wealth creation.

Start leveraging the power of Return on Capital metrics today by exploring the tools and resources available at Stock Investor IQ. Build a portfolio that stands the test of time and works towards achieving your long-term financial goals.

Happy investing!