In the First Quarter 2010 installment of Fundamental Focus, we discussed two of the more popular measures investors use to gauge the relative profitability of a company—return on assets and return on equity . Both represent management’s ability to generate profits; however, both give an incomplete picture of the capital base that management has at its disposal, since they consider only total assets (in the case of ROA) or total equity (in the case of ROE). Anyone who has taken a basic accounting course knows that the capital structure of a company is composed of assets, owners’ equity and liabilities. A third measure—return on capital, or return on capital employed —adds a company’s debt liabilities to the equation to reflect a company’s total “capital employed.”
Return on capital is used by Joel Greenblatt to identify good businesses in his popular book “The Little Book That Beats the Market” (John Wiley & Sons, 2006) and its follow-up, “The Little Book That Still Beats the Market” (John Wiley & Sons, 2010). Return on capital measures the operating profit of the tangible investment (capital) that company management uses to generate that profit. In other words, return on capital measures how much profit a company earns on every dollar invested in inventory and property, plant and equipment. The higher the return on capital, the greater the company’s ability to expand in order in grow earnings. Likewise, high profitability and earnings growth should, in theory, attract investors who, in turn, will bid up the share price.
The ROCE Formula
As we mentioned earlier, many investors use return on equity (net income divided by shareholders’ equity) or return on assets (net income divided by total assets) to judge the profitability of a business. By comparison, return on capital employed, as defined by Greenblatt and others, is calculated as follows:
ROCE = EBIT ÷ tangible capital employed
EBIT = earnings before interest and taxes, and Tangible capital employed = adjusted net working capital + net fixed assets.
This definition of return on capital uses the pretax operating earnings of a company instead of net income, which is used in the ROA and ROE calculations. By using EBIT (earnings before interest and taxes), we ignore debt levels and tax rates, which will differ from company to company. Instead, we focus on profitability from operations relative to the cost of the assets used to produce those profits.
Looking at the denominator of the return on capital calculation, tangible capital employed is used instead of total assets (used to calculate ROA) or equity (used to calculate ROE) to better capture the actual operating capital used by the business. ROE, by focusing on equity, ignores assets financed via debt, while the total assets figure used in calculating ROA includes intangible assets and other assets that may not be tied to the primary operation of the firm or assets that are financed by suppliers.
Tangible capital employed is the sum of adjusted net working capital and net fixed assets. Net working capital is typically defined as current assets less current liabilities. However, we take this one step further by narrowing our focus to accounts receivable, inventory and cash needed to conduct business less accounts payable. A company must fund its receivables and inventory, but does not have to pay money on its payables as long as they are paid off within the terms of their specific agreement. In effect, therefore, payables are an interest-free loan. Cash and short-term investments are also (usually) excluded, since they are not used to run the current operations of the company. To include cash that may not yet be employed would be to overstate a company’s capital and reduce its return on capital. Again, the focus of return on capital is on the actual capital the company has invested in its business. Lastly, net fixed assets are defined as property, plant and equipment less accumulated depreciation.
Table 1 shows the calculation of return on capital for retailers Target Corporation (TGT) and Wal-Mart Stores, Inc. (WMT), along with the relevant financial statement data. The financial data used for Wal-Mart is as of October 31, 2011, and for Target the data is as of October 29, 2011. We used AAII’s fundamental stock screening and research database program Stock Investor Pro as the source for the numbers. However, the data is easily found in SEC filings and on financial websites such as Yahoo! Finance and SmartMoney.com.
Target Corp. (TGT)
Wal-Mart Stores, Inc. (WMT)
|Quarterly Balance Sheet|
|(Millions)||As of 10/29/2011||As of 10/31/2011|
|Cash & Equivalents||$755.0||$7,063.0|
|Accounts Receivable, Net||$5,713.0||$4,757.0|
|Other Current Assets||$1,948.0||$3,316.0|
|Total Current Assets||$18,372.0||
|Net Property, Plant & Equipment||$29,040.0||$110,392.0|
|Other Current Liabilities||$3,273.0||$18,604.0|
|Total Current Liabilities||$14,139.0||
|(Millions)||12 Months Ending 10/29/2011||12 Months Ending 10/31/2011|
|Cost of Goods Sold||$47,783.0||$329,696.0|
|Total Operating Expenses||$64,603.0||$413,980.0|
|Operating Income (EBIT)||
|“Adjusted” net working capital||=||Accounts receivable + inventory + cash for business – accounts payable|
|=||$5,713.0 Mil + $9,890.0 Mil + $0.0 Mil – $8,053.0 Mil||=||$4,757.0 Mil + $44,135.0 Mil + $0.0 Mil – $37,350.0 Mil|
|=||$7,550.0 Mil||=||$11,542.0 Mil|
|Tangible capital employed||=||“Adjusted” net working capital + net fixed assets|
|=||$7,550.0 Mil + $29,040.0 Mil||=||$11,542.0 Mil + $110,392.0 Mil|
|=||$36,590.0 Mil||=||$121,934.0 Mil|
|Return on capital employed||=||Earnings before interest and taxes ÷ tangible capital employed|
|=||$5,399.0 Mil ÷ $36,590.0 Mil||=||$26,161.0 Mil ÷ $121,934.0 Mil|
Earnings before interest and taxes, the numerator of the ROCE formula, is simply the sum of operating income over the last 12 months (trailing four quarters). The adjusted net working capital figure used in the denominator ignores cash and short-term investments on the current assets side of working capital because they are not used in current operations of the firm and are assumed to not yet represent operating assets. However, some analysts include cash and short-term investments if excluding them results in a negative net working capital position.
From our calculations at the bottom of Table 1, we see that Wal-Mart has a return on capital employed of 21.5% versus 14.8% for Target. Based on these figures, Wal-Mart appears to be making better use of its capital relative to Target. A high(er) ROCE can indicate that a company can reinvest a greater portion of its profits back into its operations, to the benefit of shareholders. The reinvested capital is, in turn, employed at a higher rate of return, which helps generate higher earnings growth.
When comparing financial measures such as return on capital, it is a good idea to compare firms in similar lines of business, which is one of the reasons why we chose Target and Wal-Mart for our example. While we see that Wal-Mart’s ROCE is higher than that of Target, there isn’t a lot to be gained from using data from a single point in time. Financial analysis yields the greatest insights when analyzing trends over time. Companies that are able to generate higher returns on capital year after year are apt to have higher market valuations relative to companies that consume capital in order to generate profits. A declining ROCE may point to a loss of competitive advantage.
ROCE is especially useful for evaluating capital-intensive firms, or those that require large amounts of initial capital investment before they can begin producing products. Examples of these firms include utilities and oil and gas companies.