The return generated by the capital employed within a business can be a useful guide to its competitive strengths, and whether the company’s management are chiefly interested in enriching themselves or shareholders.
Return on capital employed in a competitive market
Picture the following scenario: You decide to set up a company which will run a lemonade stand. You buy a stand, an advertising banner, some cups, lemons and sugar, and hire an inexpensive teenager to run the business.
The total cost of the company’s fixed capital (the advertising banner and stand) plus its working capital (cups, lemons and sugar) is £1,000.
By some miracle the teenager manages to sell 1,000 cups of distinctly ordinary lemonade a day, for £1 per cup, giving you a daily sales figure of £1,000.
On that basis you assume that annual sales will be around £360,000 and if you can keep expenses below £20,000 per year (your lemonade is weak and the teenager is cheap) your annual profit will be in the region of £340,000.
Clearly you must be a business genius as your initial investment of £1,000 is now expected to earn a 34,000% annual return.
If it were that easy we’d all be running lemonade stands. However, nothing attracts attention like money, and an investment returning 34,000% a year is going to attract a lot of attention.
So in no time at all you’ll have competition; lots of competition.
Let’s say that within a week there are 10 lemonade stands competing to supply those 1,000 cups of lemonade a day, so the first thing you’ll lose is sales. You’ll be lucky if you can sell 100 cups a day, let alone 1,000.
But that’s not your biggest problem.
Customers now have a range of lemonade stands to choose. If these lemonade drinkers are like most people they’ll pick the lemonade stand that looks like it will provide a “good enough” glass of lemonade at the best price.
Unfortunately for you, some other lemonade stand owners will no doubt accept a lower return on their investment than 3,400% (which is roughly what you’d get if your daily sales dropped from 1,000 to 100) and will happily undercut your £1 price point.
Eventually, with enough competition, the price will be driven down to the point where it’s barely worth even running the stand at all.
Fortunately though, unless there is some compelling non-monetary reason to run a lemonade stand, that should be about as bad as it gets.
If the return from a lemonade stand drops so low that it’s an unattractive business to get into then no new stands will be set up as investors realise there are better things they can do with their money.
The same, although to a lesser extent, will be true of existing stand owners. If their return is below what they can get for an equally risky business (perhaps a bubble gum stand) then they may well sack their teenager, sell their remaining stock, the stand and everything else, and invest the proceeds elsewhere.
That will reduce competition, which will in turn increase returns for the remaining lemonade stands.
The opportunity cost of capital
The result of all this competition and entry and exit of new and existing competitors is that most companies return something close to the opportunity cost of their capital.
This cost of capital is simply a term which means the return you could get from doing something else, but similar, with that capital.
For most companies this means their average return on capital employed is around 7% to 10%, although it depends on exactly how you define “return” and “capital employed”. This is also the sort of return you can get by investing capital into a stock market tracker.
The importance of return on capital employed
So what does all this have to do with choosing companies to invest in?
Think of it like this:
You’re rich and you buy a large company outright. The total capital employed in the business (fixed asset plus working capital) is valued in the accounts at £2m but you manage to buy the company for £1m as you’re a good negotiator and the existing owner needs to leave the country in a hurry.
After all expenses the company makes a profit of £100k per year and pays out £40k of that as a dividend. Your investment ratios are therefore a PE of 10 and a dividend yield of 4%, both of which are reasonable for this sort of business.
The CEO keeps the remaining £60k of earnings in the business to help it grow by investing in new equipment, factories and so on, and the company has a historic growth rate of 3%.
On the face of it that sounds fine; a 4% dividend growing at 3% a year giving a total return of 7%, with some variation of course.
The problem is that you shouldn’t want any of the earnings to be retained for growth.
In its current state the business is earning a £100k profit on £2m of capital employed; that’s a paltry 5% return. Any capital (earnings) retained by the CEO is likely to earn a similar rate of return as the company’s existing capital, so the CEO is effectively taking £60k of your money and investing it on your behalf at a rate of 5%.
Return on capital employed and management incentives
So why would your CEO, or any CEO for that matter, want to invest your money at 5%?
The answer, at least in part, is because most CEO’s are not paid based on return on capital employed. Instead CEOs get paid more if the company gets bigger.
Here are three random companies, one large, one medium and one small, drawn from my portfolio:
- Vodafone: market cap £55 billion, CEO package £11 million
- MITIE: market cap £1 billion, CEO package £1.5 million
- Braemar Shipping: market cap £150 million, CEO package £400k
Clearly the general rule is that bigger companies pay bigger CEO salaries.
What would you do if your goal was to be paid as much as possible (which is rational for the CEO)?
Surely you would try to make the company as “big” as possible, which means more sales, profits and a larger market cap.
How would you do that?
Of course there are a million and one ways to grow a business, but you would certainly want to hang onto every penny of earnings so that you could reinvest them to expand the business. As long the reinvested earnings generated some additional profit you’d be making the company bigger – even if the rate of return on that capital was just 1%.
This is the opposite of how an owner would think. If you owned the whole company, would you benefit from investing money within the company at low rates of return? The answer of course is that you wouldn’t.
Rationally you’d only invest in the business in projects which you expected to pay a rate of return above what you could get elsewhere.
When you ran out of such projects you would pay any remaining earnings out as a divided, which you could then invest somewhere else (such as another company or an index tracker) at a higher rate of return.
Return on capital employed and competitive advantage
Earlier on I mentioned that most businesses, like the lemonade stand, earn a return that is somewhere around the opportunity cost of the capital employed. But that isn’t true of all businesses.
Some businesses can earn much higher rates of return over prolonged periods of time.
How do they do this?
They typically have some sort of competitive advantage, some edge that allows them to sell more products and services, or sell them at higher prices, or both, than their competitors.
They have some sort of rare asset, such as a brand name, a patent or ownership of the world’s lowest cost iron ore mine, which competitors cannot copy.
These competitive advantages are useful for at least two reasons:
- First, any earnings retained by the company are likely to earn a good rate of return in future, rather than the paltry 5% in the example above.
- Second, competitive advantages that exist over many years, which show up as consistently high rates of return on capital employed, are often defensible long into the future. This can provide the company with a more certain future than most other companies.
The upshot then is that return on capital employed (or any similar metric) is an important way to measure the quality of a company’s assets and its management.
Over the last few years I haven’t really looked at return on capital employed. I have preferred to look for companies that have long histories of profitable dividends, with consistent growth and conservative finances, topped off by attractively valued shares.
However, for all of the reasons above, I will be including a company’s long-term median return on capital employed in my analysis from now on.
Note: Banks and insurance companies have vast assets (loans and insurance float respectively) which means that return on capital employed (total assets minus current liabilities) is not a useful measure. For those companies I’ll use return on equity (total assets minus total liabilities) instead. The ROE figures for banks and insurers tend to be fairly similar to the ROCE figures for non-financial companies, which makes them broadly comparable.
Its very confusing because different sources use different metrics which are close but not exactly the same as ROCE. For example Financial Times uses Return on Investment while the US based analysts prefer Return on Capital Invested (ROCI). In addition there are a host of others such as Return on Total Capital, Return on Capital etc. Am I right in assuming ROI and ROCI are almost the same as ROCE? Also I believe that a company is only creating shareholder value when ROCE is greater than Weighted Average Cost of Capital (WACC). I find its not easy to find WACC and a pain to calculated it, however as a rule of thumb I find that if ROCE is greater than 8% I am OK and double digits is ideal. What do you think John?
John Kingham says
Yes there are lots of different ratios that measure profitability in subtly different ways, including ROE, ROA, ROTA, ROIC, ROCE, CROCI… I’m sure there are many more. And even within those ratios there are variations on how they are defined.
Personally what I’m looking for is a rough guide to the sort of returns a company might generate on earnings that aren’t paid out as a dividend.
Of course this is all subject the the usual large amount of uncertainty in both the operating business and the stock market, so I have gone for ROCE.
Usually that’s calculated as:
Operating profit / (fixed assets + working capital)
But I prefer to use profit after tax as that also has interest payments removed, which reduces the profit number for companies with more debt and lower interest cover.
For WACC I just assume a company should be producing an above average rate of return, which is something like 7% – 10% for the UK market (using profit after tax, it’ll be a bit higher for operating profit).
So double digits seems like a sensible figure to aim at. However, I’m not yet ruling companies out based on ROCE; I’ll just need a lower price to justify investing in a low ROCE business.
As you said share prices and return on capital relation is important.
What is more important is to interpret hystorical data and understand how the company creates the return on capital. It could be due to exchange rates as it is the case of Toyota Motor, and to some extent to Rolls Royce.
Myself I use CROCI. It helps me find undervalued stocks. This for example was the case when I bought Nokia 7 months before Microsoft bought it. Nokia was still having a 7% CROCI (as the wider market) however the share price was very depressed. This is a lesson, you should not always look for the top, companies with the highest CROCI etc. by the way CROCI is a value strategy.
For WACC, personally I will use 8%, made of 2% CPI inflation, 3.5% dividend yield and 2.5% GDP growth. This is my expected return on capital going forward.
John Kingham says
Hi Eugen, yes CROCI is another useful profitability measure, and as you say it’s one of a number of factors to be considered alongside value.
WACC of 8% sounds about right too, although I’m beginning to have my doubts that we’ll hit historic long-term real GDP growth rates in the future (either in the UK or globally).
Isn’t WACC stock specific? You need to use the beta and capital structure of the company. Then use CAPM or DCF analysis, its why I find it a pain.
John Kingham says
It can be, but the added complexity probably adds little value.
In my opinion my cost of capital is what I could get for it elsewhere, which usually means the general stock market return of say 8% a year.
If you’re Buffett then your cost of capital is 15% because that’s what he thinks he can reliably get.
So you can basically just pick a number and go with that. Of course riskier business should return more, but CAPM and DCF analysis usually lends false precision to things that cannot be precisely calculated.
John Dudley says
You are using a company’s ROCE in the calculation for ranking. Is a company that sustains a high ROCE and retains a large proportion of earnings to reinvest a better investment than one that pays out all of its earnings as dividend ? If so, how does the ranking system take this into account ? Admiral is presently in number 1 position and I hold it in my portfolio but to me it is less attractive because it appears that it can’t reinvest my share of its earnings at the rate it has managed historically.
I very much respect your logical approach to investing and would value your opinion on this matter.
John Kingham says
That’s an excellent question. My thinking on this is mostly driven by some things that Warren Buffett has said over the years. Basically his approach to Berkshire Hathaway’s subsidiaries is to give their management a few rules:
1) Only retain earnings where the return on those retained earnings will be above 10%-12% (or 15%, the exact rate seems to vary depending on when Buffett was speaking)
2) If retained earnings cannot reach that hurdle rate they should only be retained if they are absolutely required to keep the business running
3) Run the business as if it was the only asset and source of income your family will have for the next 100 years (i.e. don’t do anything risky and build a massive competitive moat)
So on that basis I would prefer Admiral to retain all of their earnings because their ROCE is huge at over 50%. However, they simply cannot retain those earnings at that rate of return. The number of opportunities to deploy retained earnings at those rates is limited so they pay any excess earnings back to shareholders as a very large dividend.
As to your question, yes I think a company that retains a lot of earnings at a high rate is better than one that pays them out as a dividend. So if there are two companies and they have an equally high ROCE, the one that retains more earnings at that rate of return is better. The reason it’s better is that it saves me from having to find something to do with the dividend. Finding high ROCE companies at attractive valuations isn’t easy and so I’d rather the company deploy my earnings at a high rate rather than me having to find somewhere else to put them to work.
In terms of the stock screen it becomes a bit more complex. If two companies had the same ROCE, one retaining half its earnings (low-payout) and the other retaining 1% of its earnings (high-payout) then there would be several consequences.
The dividends paid out by the high-payout company would be larger. If the two companies had the same share price the high-payout company’s PD10 ratio would be lower and its dividend yield higher, which would make it more attractive than the low-payout company.
But the low-payout company would be growing faster because it is reinvesting those retained earnings into new factories, for example, so the low-payout company would have a better Growth Rate and probably Growth Quality as well which would make the low-payout company look more attractive.
So in reality it would depend on how much of those earnings were being retained and at what rate.
But the basic principle is that high growth, high ROCE companies will rank highly, which implies a preference for highly profitable companies that retain a lot of their earnings.
Admiral ranks very well on the screen because it has a consistently high growth rate and an incredibly high ROCE. Even though it only retains a small amount of its earnings it is able to grow because the return on those retained earnings is exceptionally high.
So in somewhat simplistic terms, if Admiral can invest retained earnings with a 50% ROCE then it only has to retain 10% of its earnings (paying out 90% as a dividend) in order to grow at 5% a year. Another company with a more normal 10% ROCE would have to retain half of its earnings to grow that quickly.
At the end of the day it can be very hard to decide which company is “better”, so in general I just try to stick with owning a group of high ROCE, high growth companies at reasonable valuations, on the assumption that over time above these average companies at below average prices will beat average companies at average prices (i.e. the market).
Sorry if that answer’s a bit long! I’ll send you this reply by email as well.