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Why Return on Capital Matters

This article is the third in a series that explains how our stock screening strategy differs from all the basic offerings out there. The previous 3 articles can be found below:

  1. Market Capitalization Is Misleading, Use This Instead.
  2. The P/E Ratio Is Antiquated. Here Is Something Better.
  3. Use Free Cash Flow Yield To Find Truly Cheap Stocks

Imagine two Subway restaurants, one run by Mr. Redd and the other run by Mr. Greene.

Subway locations are pretty standardized. Most are more or less the same size. All of them offer basically the same menu at essentially identical prices. The equipment is the same: same serving counter, same quick-cook ovens, same bread baking ovens, same refrigeration systems, etc. The point is, both Mr. Redd and Mr. Greene have the same initial capital investment in their Subway locations. Just to have a close number, lets say their capital investment is $150,000.

Let's say Mr. Redd and Mr. Greene both start out grossing about $2,000 per day, with a 25% operating margin, or $500 in profits per day. That amounts to about $182,000 in pre-tax income per year, or a pre-tax return on capital of 21%. Not too shabby!

The Crafty Mr. Greene

After some years, Mr. Redd decides he wants to increase his sales by 20%. To do so, he spends $50,000 to expand his restaurant, buying new signage, and adding more tables. It works! Mr. Redd's sales increase 20% to $2,400 per day, with profits amounting to about $219,000 per year (his operating margins stayed the same). However, he now has $200,000 in capital investment, so pre-tax return on capital has fallen to 9.5%.

Subway Assembly Line

Mr. Greene, on the other hand, is an astute business man and operator. He has noticed that by specializing his employees into a sandwich "assembly line", he can service 20% more customers per hour. As a result, Mr. Greene is also able to increase his sales 20%, and since his fixed costs stay the same, he sees his operating margins rise to 28%, now pulling in $672 per day, or $245,280 per year. Best of all, since he did not expand or remodel his store, his capital investment remains $150,000, so his return on capital has risen to (($245,280 - $150,000) / $150,000), a staggering 64%!

Same businesses, same sales, similar margins... but a vastly different level of efficiency!

Why does this matter?

Why It Matters

Return on capital matters because, over the long term, it makes an ENORMOUS difference in how fast a company can compound growth in its revenues and earnings. And revenue and earnings growth are, obviously, what ultimately leads to growth in the value of a business (e.g., your stock price).

Let's beat our earlier example to death. Both Mr. Redd and Mr. Greene are happy with their Subway business models and are thinking about expanding.

Mr. Redd's version of Subway requires a $200,000 capital investment, while Mr. Greene's requires only a $150,000 investment. To keep it simple, let's just assume that both of them will plow all of their profits back into new stores. How fast can they grow in 5 years?

Mr. Redd

Remember, Mr. Redd earns $219,000 per store per year and the cost of his new stores are $200,000.

YearProfits to ReinvestNew StoresLeftover Profits

Mr. Redd does pretty good, ending the 5 years with 31 stores and annual pre-tax earnings power of about $6.8 million.

Now let's see how Mr. Greene fares.

Mr. Greene

Remember, Mr. Greene earns $245,280 per store per year and the cost of his new stores are $150,000.

YearProfits to ReinvestNew StoresLeftover Profits

Quite a difference! Mr. Greene's efficient business process has allowed him to end the 5 years with 84 stores and total pre-tax earnings power of over $20 million dollars! That is more than triple Mr. Redd's earnings power. If you owned shares in both businesses, it is quite obvious that the investment in Mr. Greene's business would have been worth a LOT more after 5 years:

Redd vs. Greene

Return on Capital Makes A Huge Difference

Although this is a really simplistic (and unrealistic) example, it illustrates how strong returns on capital can have ENORMOUS impacts on a business over a several year time period. Simply put: capital efficiency is a huge differentiator that is not often obvious looking just at revenues and profit margins. That's why they are an important part of our screening tools, as well as our Magic Recipe and Quality Growth Spells.

Next week, I'll go into a little more detail about the different variations on return on capital we can use. Follow our newsletter to get the updates right into your inbox!

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