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.