Return on Capital
...and Return on Equity
by Dale Wettlaufer (TMF Ralegh)
ALEXANDRIA, VA (Oct. 14, 1998) -- In stating our approach to valuation, I don't think there is anything as important as the premise that economic value is created when a company can generate a higher return on capital than the cost of that capital. Qualifying and quantifying "return on capital" and "cost of capital" are pursuits to which Alex and I have applied ourselves in our columns in the Evening News and in the other work that we've done for the Fool. I suspect that we will spend a good deal of time thinking out loud on these subjects as we go forward with the Boring portfolio, and I know that we'll spend much time with the application of these concepts in qualifying prospective investments and quantifying their values.
At the end of this column, I'll include a number of links to the various columns we've written on return on invested capital, or ROIC. But let's go over some of these concepts right here. The idea behind ROIC is that we want to measure the cash output of a business relative to the cash that we put into it. If a company requires $100 in capital to operate and spits out $3 in cash every year, and forevermore needs $33 in capital to create a dollar in return, then we aren't going to be that interested in that business. And we won't care if the thing is growing at 25% per year, either. We can always put that $100 in highly liquid bonds and get $5 back.
Many investors become familiar with return on equity (ROE) as their first measure of return on capital. ROE measures the net output of an enterprise relative to the capital equity investors put into the company. Depending on the situation, we may use ROE, but as a more general way to measure profitability of capital, we depend upon ROIC. The reason is that return on equity rewards highly leveraged capital structures and indicates a high level of profitability even if a company is only mildly profitable. (Below, I've linked in another series we did on ROE that demonstrates this principle.) When we look at a company, we want to measure how well it rewards investors, regardless of whether those investors are equity investors or lenders.
Say, for instance, a company has an average balance sheet over the course of the year that looks like this:
Assets.............$1,000 Accounts Payable...$400 Debt @10%..........$400 Owners' Equity.....$200
If the company generates net income of $30 and after-tax operating income of $56, its ROE would be 15% (net income divided by owner's equity), which by most standards is pretty good. On a ROIC basis (after-tax operating income divided by invested capital -- which is owners' equity plus debt, or assets minus non-interest bearing short-term liabilities), though, its return on invested capital would be 9.3%. That's sufficient to pay the after-tax cost of its debt, but it barely beats its overall cost of capital of 8.8%. Cost of capital is calculated by multiplying the after-tax cost of each component of capital by its weighting in the company's capital structure.
Assuming this company is selling at two times book value, the company's calculated cost of capital would be:
Debt....6.5% after-tax cost x weighting of 50% = 3.25% at 35% tax rate Equity...11% after-tax cost x weighting of 50% = 5.5%
Adding the two together, the company's weighted average cost of capital (WACC) is 8.75%. Now, this isn't a horrible return on capital and there's nothing wrong with the ROE on the face of things, but the growth rate of the company would play heavily into the price we would pay for this company. If it's a no-growth situation, we wouldn't be highly attracted to the company. We can show this via a discounted cash flow model, which is something we'll work up every time we look at a company, but an easy and accurate shorthand for the yield on our invested capital is available.
Remember that we said the company was selling at twice book value. That works out to a price of $400. Adding the debt to this, we get a current enterprise value of $800. That works out to a 1.33 multiple of enterprise value to invested capital. Dividing the return on invested capital of 9.3% by 1.33 indicates a yield of 6.98%. In a no-growth situation, this isn't sufficient for us to take on this risk, as it's below our cost of capital. Priced at book value, however, and in a no-growth situation, we would be more inclined to look at the company, as the return on the capital we would have to invest in the company would approach a more attractive level.
Going forward we'll refer to this ratio the Boring Ratio. That's for purposes of ease in referring to it. We're not trying to compete with the Cash-King guys, who have their own ratio called the Flow Ratio.
Links to more on ROIC and ROE --
Stock Change Bid ANDW +2 5/16 13.69 CGO - 1/16 25.38 BGP --- 23.75 CSL --- 33.38 CSCO +1 7/16 52.13 FCH - 1/16 19.94 PNR + 3/8 30.88 TBY - 1/8 6.06
Day Month Year History BORING +1.54% -7.69% -21.01% -0.61% S&P: +1.07% -1.13% 3.62% 61.76% NASDAQ: +2.09% -9.03% -1.87% 48.03% Rec'd # Security In At Now Change 6/26/96 225 Cisco Syst 23.96 52.13 117.59% 2/28/96 400 Borders Gr 11.26 23.75 110.99% 8/13/96 200 Carlisle C 26.32 33.38 26.78% 3/5/97 150 Atlas Air 23.06 25.38 10.05% 4/14/98 100 Pentair 43.74 30.88 -29.42% 5/20/98 400 TCBY Enter 10.05 6.06 -39.65% 11/6/97 200 FelCor Sui 37.59 19.94 -46.96% 1/21/98 200 Andrew Cor 26.09 13.69 -47.54% Rec'd # Security In At Value Change 6/26/96 225 Cisco Syst 5389.99 11728.13 $6338.14 2/28/96 400 Borders Gr 4502.49 9500.00 $4997.51 8/13/96 200 Carlisle C 5264.99 6675.00 $1410.01 3/5/97 150 Atlas Air 3458.74 3806.25 $347.51 4/14/98 100 Pentair 4374.25 3087.50 -$1286.75 5/20/98 400 TCBY Enter 4018.00 2425.00 -$1593.00 1/21/98 200 Andrew Cor 5218.00 2737.50 -$2480.50 11/6/97 200 FelCor Sui 7518.00 3987.50 -$3530.50 CASH $5750.59 TOTAL $49697.47