How To Calculate Return on Capital
This article is the fifth in a series that explains how our stock screening strategy differs from all the basic offerings out there. The previous 4 articles can be found below:
- Market Capitalization Is Misleading, Use This Instead.
- The P/E Ratio Is Antiquated. Here Is Something Better.
- Use Free Cash Flow Yield To Find Truly Cheap Stocks
- Why Return on Capital Matters
Last week, we went over why considering a company's return on capital is important to finding the best investment candidates.
Today, I want to go into a little of the nitty gritty on the different return on capital calculations for our stock screening "Spells" and the Spell Caster screener.
What is Invested Capital?
To calculate a return on capital, first of all you have to define what exactly "capital" means.
Specifically, what is a company's "invested capital"?
Invested capital are what a company is using to generate earnings and cash flows.
Going back to our Subway example, the invested capital in the Subway starts with the total current value of the food inventory, serving counter, ovens, the refrigerators, the soda dispenser, the tables and booths, and so on. We subtract from this near-term liabilities such as outstanding supplier invoices, unpaid employee salaries, and so forth, because - to this point anyway - that is "free" capital being used to generate profits. The longer a company can put off paying for its liabilities, the better its cash flow.
Invested capital does *not* include assets the company possesses that are not employed in generating earnings or free cash flow. For example, if Mr. Greene has $150,000 invested in his Subway, but also keeps $20,000 in cash in the bank for emergencies, that $20,000 is NOT considered invested capital. That cash is not making any money for his business. This is what we refer to as excess cash.
Invested capital also does not include financial liabilities such as long-term debt. Remember, in a return on capital calculation, assets are considered "bad", not liabilities. The contribution of debt as capital to generate cash flow or profits shows up as the assets purchased with that debt.
Given all this, invested capital is calculated as so:
Invested Capital = Total Assets - Short-term Non-debt Liabilities - Excess Cash
Believe me, I understand this is difficult to get your head around - it took me a while too! Just focus on the purpose - estimating the cost of ONLY the capital assets used to generate income.
Subscribers can see these calculations in action by searching any ticker in the search box from the site banner.
Return on Capital vs. *Cash* Return on Capital
Our Spells and screeners offer two categories of return on capital: plain "vanilla" return on capital and *cash* return on capital.
The distinction is quite simple and analogous to the difference between earnings yield and free cash flow yield. The difference in those two calculations is simply the numerator being EBIT vs. free cash flow. In both cases, the denominator is the enterprise value.
Likewise, in the return on capital calculation, in both cases the denominator is the invested capital number. So we are literally measuring the same thing, just based on earnings vs. cash flow.
Return on Capital = EBIT / Invested Capital
Cash Return on Capital = Free Cash Flow / Invested Capital
Like the yield values, I see the distinction as being a layer of protection against accounting nonsense. If, at a glance, the regular and cash returns on capital were in the same ballpark, I wouldn't think too much about it. However, if the cash return on capital was far lower, it would raise a red flag and be a point of concern for more detailed analysis.
Total Capital vs. Tangible Capital
I think Joel Greenblatt's Magic Formula strategy is brilliant in its simplicity, and by all means I wanted to preserve the essence of it with the Magic Recipe Spell. In The Little Book that Beats the Market, he makes very clear that his return on capital component uses only tangible capital calculations, so that is what I use as well.
Return on Tangible Capital = EBIT / (Total Capital - Goodwill - Intangible Assets)
However, I don't really agree with that decision. By subtracting goodwill and intangible assets from invested capital, Greenblatt is not penalizing companies that use overpriced acquisitions to grow.
By offering return on total capital as a screening option, I WILL penalize those firms that grow by blowing shareholder capital on richly valued takeovers. Look, if a company is putting shareholder cash into buying other companies, the overpay should be treated as invested capital in my book. They have to earn an excellent return on those acquisitions to generate a solid return on total capital number.
This article is a bit wonky, I'm sure, but these are some of the things I'm asked about most frequently. I also hope it clears up the different return on capital metrics offered by our screening tools. In a nutshell, I prefer return on total capital over tangible capital, and believe comparing "regular" vs. cash return on capital is a good check for accounting red flags.
Joel Greenblatt and MagicFormulaInvesting.com are not associated in any way with this website. Neither Mr. Greenblatt or MagicFormulaInvesting.com endorse this website's investment opinions, strategy, or products. Investment recommendations on this website are not chosen by Mr. Greenblatt, nor are they based on Mr. Greenblatt's proprietary investment model, and are not chosen by MagicFormulaInvesting.com. Magic Formula® is a registered trademark of MagicFormulaInvesting.com, which has no connection to this website. The information on this website is for informational purposes only and solely represents the views and opinions of the author. No warranty is provided or implied as to the accuracy, completeness, or timeliness of this information. This information may not be construed as investment advice of any kind, nor can it be relied upon as the basis for stock trades. DON'T RELY SOLELY ON THIS WEBSITE'S INFORMATION OR STATISTICS! Please do your own research before buying. Alexander Online Properties LLC, the proprietor of this website, is not responsible in any way for losses or damages resulting from the use of this information. Alexander Online Properties LLC is not a registered investment advisor. All logos are trademarked properties of their respective companies.
© 2008-2017 Alexander Online Properties LLC