Return on capital metrics are one of the best ways to assess the quality of a business. As such, they are an integral part of any quality stock screener criteria. This article will cover the most important return on capital measures and how to incorporate them into your stock screens.
If you would like a broader overview of quality investing/screening, you should read this article for quality stock screener tips.
What are Return on Capital Metrics?
Return on capital metrics are profitability ratios that tell you how efficiently a company turns its capital into profits.
As such, they measure the effectiveness of a company’s capital allocation decisions. They are also arguably the best shorthand expression of its industrial positioning and competitive advantages.
In a perfectly competitive market, companies make zero economic profits. With no barriers to entry or any product differentiation, there will always be a competitor that undercuts on pricing. To maintain market share, other companies then have to lower prices themselves. Overtime, this drives return on capital down to the cost of capital.
Therefore, achieving sustained high returns on capital (above the cost of capital) requires possessing features that protect returns from competition; namely, competitive advantages.
Since quality companies possess these competitive advantages, they tend to have have high returns on capital. As such, screening for companies with high return on capital metrics is a good way to find quality companies.
Implementing Returns into Stock Screener Criteria
There are generally three approaches you can take when incorporating returns on capital into your stock screener criteria:
- Screen for companies with the highest absolute returns in a stock universe
- Screen for companies with higher returns than their industry peers
- Or, screen for companies whose returns have been growing in recent years
Since returns can be volatile from one year to the next, it is usually best to look at how returns have trended over the last few years (3-5 years) and take an average. This will help you assess whether a company has been able to sustain or grow their competitive advantage.
1) Absolute Return on Capital
In the first approach above, I am looking for companies with the highest returns in a certain stock universe. For example, I could get my stock screener to find the top 20, or the top 10%, of stocks in the S&P 500 with the highest 5-year average return on capital.
Alternatively, I could set a minimum threshold that I want companies to meet. For example, I could tell my stock screener to find companies with a return on capital of at least 15%.
2) Relative Return on Capital
In the second approach, I am acknowledging the fact that returns vary from industry-to-industry. This is usually due to differing capital-intensity and competitive pressures. If I am not necessarily concerned about owning stocks in lower quality industries and just want to find the best ones within each, then I can screen for stocks that have higher returns than their industry average.
If a company has sustained greater returns than their peers, this signals that they enjoy a competitive advantage over them.
3) Increasing Return on Capital
The third approach can help us identify companies that are growing or establishing a competitive advantage. You can use it on its own, or in conjunction with the other two methods.
Some investors not only like to see high returns, but also returns that have been growing. A company with declining returns in recent years, may signal that it is succumbing to the competitive pressures outlined earlier.
Now let’s dig into the different return metrics investors analyse…
What’s the Difference Between ROE, ROIC, and ROCE?
Below, I breakdown the key differences between the most common return on capital metrics. For those interested, you can obtain other fundamental ratios like these from a platform like Koyfin.
Return on Equity (ROE)
ROE is a measure of shareholder returns calculated by dividing net income by shareholders’ equity.
We can expand this formula using DuPont analysis. This allows us to deconstruct the key drivers of returns into three different components.
Profit margin reflects the benefit of incremental sales. Asset turnover measures how efficiently a company generates those sales from additional assets. And financial leverage tells us to what extent those assets are financed by equity holders.
By deconstructing the formula like this, we isolate the individual factors driving returns. This helps investors assess if there are specific problems hindering returns. Are returns low because of profitability issues, for example? If so, then we should focus on how the company plans to increase margins going forwards.
Whilst ROE can be useful as a general proxy, the figure is crude for two reasons. Firstly, the return part of the equation (net income) uses accounting measures. This leaves managers with considerable discretion over the treatment of measures such as depreciation and provisioning.
Secondly, factors that affect the value of shareholders’ equity (such as write-downs and debt levels) can distort the calculation. Debt is particularly problematic, since the leverage effect boosts return on equity but does not reflect the associated risks.
To solve the first problem, we can used cash-based measures such as FCF to remove any accounting distortions. You will see this done in some of the calculations below.
To solve the second problem, we can use a more comprehensive measure of capital as opposed to just using equity. You will see two versions of this in the formulas below: invested capital, and capital employed. Both are vaguely similar and include debt in their calculation, which removes the effect that capital structure has on returns.
Cash Conversion Ratio (CCR)
The cash conversion ratio measures the percentage of earnings collected as cash i.e., the quality of earnings.
Where CFO = cash from operations, and FCF = free cash flow. CFO and FCF are interchangeable due to their close link: FCF = CFO – CAPEX
Cash conversion reflects a company’s working capital intensity and the conservatism of its accounting policies. If a company’s cash flow is small relative to its earnings, then accounting profits are overstating the amount of cash coming in and/or understating the amount of cash going out of the business. This is usually because too much cash is tied up in working capital.
Therefore, it can be useful to look at a company’s cash conversion ratio alongside accounting-based return measures such as ROE, as this will reveal any accounting distortions and tell us whether the returns reflect actual cash generation.
Cash is key to the value-creation process, as it is only with cash that companies can take advantage of high-return growth opportunities and/or reward shareholders. It is preferable if this cash is generated internally from operations, as opposed to raising debt or issuing new shares. Debt makes the business riskier, while equity dilutes existing equityholders.
Therefore, screening for companies with high cash conversion rates can help identify those with quality characteristics. Our stock screener criteria should look for cash conversion rates close to 1 (100%) to find quality companies. For reference, the average cash conversion rate of a company in the Fundsmith Equity Fund has ranged between 95% and 102% over the last 8 years.
Return on Invested Capital (ROIC)
Return on invested capital tells you how much post-tax operating profit a company generates for each dollar of invested capital.
Where NOPAT = net operating profit after tax, EBIT = earnings before interest & taxes (operating profit), and T = effective tax rate.
Invested capital is the capital supplied to a company by all its investors: debtholders, and equity holders. It is the sum of a company’s book value of equity and total debt, including any capital leases in the debt figure.
Unlike ROE, ROIC uses NOPAT as the profit measure instead of net earnings. This is appropriate because we need to consider not only the profits available to stockholders (net profit), but also to debtholders (interest).
ROIC is useful for comparing the operating performance of companies in the same sector. Those with a higher ROIC are more efficient at allocating the capital given to them by outside investors and generating profits.
Comparing a company’s ROIC against its weighted average cost of capital (WACC) is another way to judge whether a company is adding any economic value to the capital supplied to them. If ROIC is greater than the cost of capital, then a company is earning an economic profit.
As mentioned earlier, by including debt in the calculation of invested capital, we remove the leverage effect from the ROE calculation. Therefore, ROIC is a more relevant measure than ROE when analysing highly indebted companies.
The main problem with ROIC is the fact it uses an accounting-based measure for the return component (NOPAT), which as I explained earlier, can be manipulated with accounting tricks. Luckily, there are certain adjustments that help resolve this.
Cash Return on Invested Capital (CROIC)
Cash return on invested capital is a variation of ROIC that uses FCF in the numerator instead of NOPAT.
This is a ‘cleaner’ measure of returns than ROIC, as management can’t manipulate FCF with accounting chicanery. Besides, investors should be more interested with the amount of cash a business generates anyway, as cash is what ultimately drives the value-creation process.
Just as we used DuPont analysis to deconstruct the ROE formula, we can do the same with CROIC:
Therefore, CROIC is driven by profit margins, capital turnover (similar to asset turnover), and cash conversion.
A company excelling in all three will be one that is highly profitable, efficient at generating sales, and convert a high proportion of its profits into cash i.e., a quality company.
Return on Capital Employed (ROCE)
Return on capital employed is another measure of financial performance calculated by dividing operating profit by capital employed.
ROCE is similar to ROIC save for a few minor differences. First, operating profit, or EBIT, is in the numerator instead of NOPAT. EBIT is a pre-tax measure of operating profit, whereas NOPAT is a post-tax measure. Therefore, ROCE is better for comparing companies across geographies with different tax rates.
Second, capital employed is the measure in the denominator – not invested capital. Capital employed is a company’s total assets minus current liabilities, or expressed another way, equity plus non-current liabilities.
Invested Capital vs Capital Employed
This differs from invested capital in that it excludes short-term debt (part of current liabilities) but includes other non-interest-bearing liabilities such as pension liabilities and deferred revenue. Since capital employed considers these extra liabilities on top of the (long-term) debt issued, it is a more complete measure of a company’s total capital.
There is a constant debate about how to treat certain items such as provisions, pension liabilities, deferred tax assets, and cash when calculating these measures of capital, and you will find different variations on the internet. The truth is that it will vary from company-to-company and from analyst-to-analyst, based on a subjective assessment of each item’s importance to that company. This is slightly beyond the scope of this article though.
If you really wanted to, you could make enough adjustments so that capital employed and invested capital are strictly equal. Some analysts even use capital employed and invested capital interchangeably due to their similarities, so I wouldn’t get too bogged down in the semantics of each definition.
The main thing to takeaway is from whose perspective each measure is most relevant for. ROE is most relevant from the perspective of shareholders, ROIC from the perspective of all investors, and ROCE from the perspective of the company.
Since ROCE is most relevant from the company’s perspective, it is the preferred metric of investors like Terry Smith, who are always analysing an investment as if they were to buy the whole company.
In addition, ROCE is one of the 2 ratios that form a magic formula stock screener strategy.
Cash Return on Capital Employed (CROCE)
Cash return on capital employed is a variation of ROCE that uses FCF as the profit measure instead of EBIT (operating profit).
Using DuPont analysis, we can deconstruct CROCE into the three components below:
This is essentially the same formula as CROIC, except capital turnover uses capital employed in the denominator instead of invested capital – the difference of which was explained above.
A common theme should becoming apparent now: high quality returns are driven by profitability, capital efficiency, and cash-generation.
Summary
- Return on capital metrics measure the efficiency with which a company turns its capital into profits.
- They therefore reflect a company’s capital allocation decisions and its competitive advantages.
- Quality companies excel in these areas, and so have high returns on capital.
- For a complete picture, investors should look at a combination of ROE, ROIC, and ROCE to remove accounting distortions.
- Alternatively, cash measures of these ratios can also give you a ‘clean’ picture of returns.