Return on Capital Calculations and Ratios provide measures of quality for the value analyst searching for long term investments.
Investors who choose to look for more than just value need metrics with which to search for companies that deliver excess returns on capital. Without such metrics the value investor should concentrate only on purchasing investments at a deep discount and selling them when they approach intrinsic value .
A long term investor (i.e. Warren Buffett) not only aspires to purchase assets at a discount, but attempts to buy companies that are earning excess returns. This is the only way a company can sustain an above average growth rate.
Notes on Return on Capital (ROC)
There are no standard formulas for these ratios. Be careful when exploring on the internet. I found many different formulas, some of them variations that made sense, and some that were just plain incorrect.
Related: What is the Capital Asset Management?
If you really want to dig deeply into the subject I recommend ROC, ROIC, and ROE: Mearsurement and Implications, by Aswath Damodaran. The professor’s paper takes the subject much further and in-depth than I can here.
These are ROC ratios and calculations that analysts use to determine which companies have the potential to be long term holdings:
1. Return on Invested Capital (ROIC)
The ROIC ratio measures the return achieved on equity and debt capital invested by the entity. For value investors looking for quality this is one the most popular and valuable metrics:
Return on Invested Capital (ROIC) = Net Operating Profit After Taxes (NOPAT) / Book Value of Invested Capital
where….
Net Operating Profit After Tax (NOPAT) = Net Profit After Tax + After Tax Interest Expense – After Tax Interest Income + Goodwill Amortization (if any)
(Note: NOPAT is equal to Net Income for companies with no debt and interest expense. In other words, NOPAT is the amount that that would flow to shareholders if the company is debt free and therefore has no interest.)
Invested Capital = Current and Non-Current Portion of Debt (Total Long Term Debt) + Shareholders Equity + Minority Interests (Y-Charts definition)
(Note: There is no standard formula for Invested Capital. I am using Y-Charts definition throughout the post because I use it and think it’s a good measurement.)
OR
Since Operating Profit and EBIT are the same you can figure ROIC with EBIT after making an adjustment for taxes:
Return on Invested Capital (ROIC) = EBIT (1 – tax rate) / Investing Capital
where…
EBIT = Earnings Before Interest & Taxes
(1 – tax rate) = This is a theoretical estimate of the effective or marginal tax rate. This adjusts EBIT to an after tax estimate.
Invested Capital = Current and Non-Current Portion of Debt (Total Long Term Debt) + Shareholders Equity + Minority Interests (Y-Charts definition)
Return on Invested Capital (ROIC) Calculator
2. Cash Return on Invested Capital (CROIC)
CROIC is related to ROIC with a slight alteration. The numerator is Free Cash Flow (FCF) instead of Net Income. Some investors replace Free Cash Flow with Warren Buffet’s metric Owner Earnings since they are similar:
Cash Return on Invested Capital (CROIC) = FCF / Invested Capital
where….
Free Cash Flow (FCF) = Operating Cash Flow (OCF) – Capital Expenditures