Invested Capital = Current and Non-Current Portion of Debt (Total Long Term Debt) + Shareholders Equity + Minority Interests (Y-Charts definition)

CROIC tells you how much free cash flow the company is generating for every dollar invested in capital.

3. Magic Formula Return on Capital

Joel Greenblatt made the Magic Formula famous in his book “The Little Book That Beats the Market” (Amazon Link). Greenblatt’s formula combined a price ratio with a quality ratio to produce the “Magic Formula. The quality half of the ratio is:

Magic Formula Return on Capital = EBIT / (Net Fixed Assets + Working Capital)

where…

EBIT = Earnings Before Interest & Taxes

Net Fixed Assets = Property, Plant & Equipment – Depreciation & Amortization

Net Working Capital = Current Assets – Current Liabilities

I find it interesting that Tobias Carlisle’s research on the Magic Formula found that the price half of the formula is extremely proficient at finding value investments. However, he found that the quality half (return on capital) did not provide any benefit to the consistency of the findings. You can find his analysis in Deep Value: Why Activist Investors and Other Contrarians Battle For Control of “Losing” Corporations (Amazon Link) Pg. 54 – 69.

4. Return on Capital Employed (ROCE)

Again, there is no set formula for ROCE. You will find several different descriptions if you do an internet search. I am using the definition used by Y-Charts:

Return on Capital Employed (ROCE) = EBIT / Capital Employed

where…

EBIT = Earnings Before Interest & Taxes

Capital Employed = Total Assets – Current Liabilities

A more accurate version of ROCE is:

5. Return on Average Capital Employed
The following is the Y-Charts definition of ROCE, but it is actually :

Return on Average Capital Employed (ROACE) = EBIT / Average Capital Employed

where…

EBIT = Earnings Before Interest & Taxes (EBIT)

Capital Employed = Average Total Assets (Annual) – Average Total Current Liabilities (Annual)

For most investors it would be sufficient to use: Capital Employed = Total Assets – Current Liabilities (instead of average). This makes the calculation easy if you are not using Y-Charts.

Return on Capital Employed (ROCE) Calculator

(Note: One downfall of ROCE is that it does not deal with the fact that depreciation and amortization will be different for every entity. Therefore companies with heavily depreciated assets may have their ROCE increase without an actual increase in profits.)

Capital Returns and Quality

A value investor looking for long term holdings must consider quality metrics as well as value metrics. In order to grow and compound earnings a company must generate capital returns higher than its cost of capital. Of course, the higher the returns the better.

Return on capital ratios provide the value investor with quality metrics that can be employed after, or along side, valuation metrics. This allows the long term investor to look for “wonderful companies at a fair price” (Warren Buffett).

This article has been republished with permission from Arbor Investment Planner. 

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