by CI Staff
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.
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