The Return on Capital ratio explained.

The Return on Capital (ROC) is a “profitability ratio” used to measure the efficiency in which a business allocates its capital to generate profits. Return on capital is one of the best ratio’s that investors can use to determine whether a business will make a viable investment opportunity. The capital return ratio shows how much operating income (EBIT) is generated for every dollar invested in capital.There are two types of capital return ratios: ROCE (Return on Capital Employed) and ROIC (Return on Invested Capital). Both are used when valuing the capital returns on a business and each have a place which we will explore further below.

When a company is showing a high ROIC/ROCE it means that it needs less capital to grow its earnings. The higher the capital return the better off the company likely is at generating long-term profits. Like our Return on Equity ratio, high and sustained returns are a great indicator of a business with a competitive edge and are usually doing something right.

Companies that achieve excess returns on capital year after year are what we call compound machines. Management teams that are wise “capital allocators” tend to grow shareholder value significantly over the long term. A higher return can indicate that a company is required to spend less to generate more profit.

• High ROIC/ROCE means the capital allocation strategies are efficient and aligned.
• Low ROIC/ROCE may mean the company is not investing it’s capital wisely.

What is the Return on Capital formula?

ROCE (Return on Capital Employed)

• ROCE = EBIT ÷ Capital Employed (Total Assets – Current Liabilities)
• EBIT = Found on the income statement and also known as Operating Profit.
• Capital Employed = Found on the balance sheet and is simply the total assets minus the Current liabilities.

ROIC (Return on Invested Capital)

• ROIC = NOPAT ÷ Capital Invested.
• Written in a different way ROIC = (Net Income – Dividends) ÷ (Debt + Equity)
• NOPAT = Found on the Income Statement.
• Capital Invested = Found on the Balance Sheet.

What are some of the differences?

ROIC is a measurement of efficiency, representing the profit earned by a company relative to the capital invested in the business. ROCE is a performance ratio which measures the return a business makes on the capital employed, taking into account the cost of debt and cost of equity to give a more accurate overall picture of a company’s profitability.

1. ROCE is based on pre-tax figures while ROIC is based on after-tax figures.
2. ROCE’s scope is much broader than ROIC since it considers all the capital employed.
3. Companies with large cash holdings can have a much lower ROCE than ROIC.
4. ROCE is a good indicator of a company’s management ability to generate revenue.
5. ROIC is a good indicator of the productivity of the company’s working capital.

Comparing a company’s capital return with its cost of capital (WACC) reveals whether invested capital was used effectively.

How to use the ROC ratio?

First we will show a simple example using the ROCE model taking two companies using their EBIT and Capital Employed figures.

Return on Capital Employed	Company A	Company B
EBIT	$500,000	$3,000,000
Capital Employed	$2,000,000	$15,000,000
ROCE	25%	20%

We can see that Company B all though it is a bigger company does not have a higher return on it’s equity. It shows that Company A is is more efficient in capital allocation. This means that Company A is taking $1.00 in funding and able to reinvest it and generate $1.25.

Here is a another example using ROIC laid out in a slightly different way.

Return on Invested Capital	Company A	Company B
NOPAT	$10,500,000	$7,500,000
Total Debt	$20,000,000	$12,000,000
Total Equity	$30,000,000	$21,000,000
Cash & Cash Equivelants	$5,000,000	$10,000,000
ROIC	23.33%	32.60%

So, in this example we divide the NOPAT of each company by the capital invested to come up with our return. All though this is a very simple explanation it shows the methodology behind this ratio.

• Company A is taking $1.00 and turning it into $1.23.
• Company B is taking $1.00 and turning it into $1.32.

Working out the ratios can get quite complex depending on the type of company you are dealing with and the industry. Sometimes there are a lot of areas that need to be added back or removed from the financial statements to come to very accurate returns on capital.

In Summary…

Value is created when a business can earn excess returns on its investment activity above the cost of its Weighted Average Cost of Capital (WACC), which we will write separately on.

Whilst this is by no means an in-depth explanation of both the ROIC and the ROCE (which will no doubt require its own blog), the one piece of information I want you take away is a high return on capital is a good sign for a business.

If a company has a sustained and high return of say 20% over a long-time frame, it is reflective of some sort of durable MOAT and wise capital allocation.

Return on Capital is the Gold Standard to me and a cornerstone ratio I use when I evaluate a business. I compare companies against competitors or benchmark against industries to find those rare businesses that are exceptional at compounding capital and as a result increasing shareholder returns. Capital Allocation is one of (if not the most important) roles of the management team, if they effectively grow the return on every dollar invested, they are creating long-term value.

Once again if you invest in a company with high and consistent returns on capital your returns will often mirror it.