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Why Negative Return On Capital Can Be A Good Thing

Since rolling out the new screener and stock statistical distribution tools, one question I've been asked several times is:

Why does a negative return on capital figure rank higher than positive ones?

It is a completely logical and counter-intuitive question that I myself struggled with when developing these. So today, I wanted to write up a quick article explaining exactly why a stock may have a negative figure and why that is actually a good, not a bad, thing.

How To Calculate Return On Invested Capital

A return on invested capital percentage by the book is fairly straightforward:

ReturnOnInvestedCapital = Earnings / InvestedCapital

In The Little Book That Beats the Market (and its spinoffs), Joel Greenblatt concentrates on earnings before interest and taxes, or EBIT, minus any obvious one-time charges or credits. So the "Earnings" part is relatively straightforward.

The Little Book That Beats The Market

The "InvestedCapital" part is a bit less clear. The simplest Invested Capital calculation comes from Morningstar:

InvestedCapital = TotalAssets - ExcessCash - NonInterestBearingCurrentLiabilities

Great, so the last question here is: how do you calculate ExcessCash?! There are several theories. My personal opinion is that ExcessCash is cash that is not needed to cover current liabilities:

ExcessCash = Cash - MAX(0; (CurrentLiabilities - CurrentAssets + Cash))

That may be a bit confusing but the point is that if non-cash current assets don't cover current liabilities, you need to "borrow" some cash to cover them, making it not excess.

Two final adjustments. Greenblatt expresses his distaste for intangible assets in his books, and minority interest should be subtracted out since we want to examine only our share of the business. That gives us a final equation (visible in the stats calculator) of:

TangibleInvestedCapital = TotalAssets - Intangibles - CurrentLiabilities + ShortTermDebt - MAX(0; ExcessCash) - MinorityInterest

Why Invested Capital May Be Negative

Let's take a look at the calculation for a current Magic stock, DHI Group (DHX), which runs several niche specific job websites:

TangibleInvestedCapital=TotalAssets - Intangibles - CurrentLiabilities + ShortTermDebt - MAX(0; ExcessCash) - MinorityInterest
=414 - 311 - 117 + 3 - MAX(0; -33) - 0
DHI Group

Our invested capital calculation comes back negative. Why is this? 2 main reasons:

  1. The vast majority of DHI's assets are intangibles, specifically goodwill from several acquisitions. When you subtract those out and consider the low hard capital requirements of Internet-based business, very little in assets are required to run the company.
  2. DHI runs subscription-based websites, meaning it collects cash up front before providing services. This leads to a large deferred revenue liability (77% of current liabilities).

In short, the company's business model requires very little in hard assets and collects cash before providing services. Those are 2 very positive attributes!

When Negative Invested Capital Is Bad

Of course, invested capital can also be negative for "bad" reasons.

The most common one is if the company runs a highly negative net equity balance sheet, for example. This is when (non-debt) current liabilities are greater than tangible total assets. In this situation, a company is theoretically in liquidity trouble as it may not be able to meet all of its short-term obligations.

However, this is actually a very rare scenario in practice. There are plenty of companies that have balance sheets with negative equity, but in almost all cases this is due to high long-term debt burdens, which are not used in our calculation of return on capital.

Wrap Up

In conclusion, for the purposes of the "Magic" calculations, negative return on tangible invested capital should be considered a good thing, and rank above positive values. I hope this article has helped to explain why!

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