The Importance Of Return On Capital

Some Simple ROIC Formulas

The concept of return on capital can be calculated in a variety of ways. Perhaps the simplest is return on assets (ROA). The return on assets equation measures the profit earned on each dollar of raw assets (buildings, cash, equipment, inventory, and so forth). The calculation here is:

Return on Assets = Net Income / Total Assets

Before moving on, I want to point out that any return on capital equation can also be calculated by substituting "free cash flow" for "net income". In a lot of ways, this is even better. Net income involves a lot of wonky accounting assumptions like depreciation, tax allocations, stock-based compensation, intangible asset impairments, and so forth. Put simply, "net income" can be gamed. Free cash flow is not as easy to fudge... this is the cold, hard cash brought in (or burned) by the company during the reporting period. So, "Cash Return on Assets" would be:

Cash Return on Assets = Free Cash Flow / Total Assets

Return on equity is the profit earned on each dollar of equity capital - in essence, each dollar you own of the company. This is a bit more meaningful because it takes a firm's liabilities and debt into account and gives a better estimate of what net capital actually is. The calculation(s) here:

Return on Equity = Net Income / Total Equity

Cash Return on Equity = Free Cash Flow / Total Equity

There are problems with each of these measures, however. Return on assets is a useful equation for comparing firms within the same industry; for example, comparing United Airlines (UAL) against Spirit Airlines (SAVE). However, it is usually not useful for comparing firms in different industries with different capital requirements, and it also does not take into account what assets are actually employed in generating profits and which are "extra".

Return on equity, on the other hand, is somewhat better as it does subtract out liabilities. However, it can present a skewed picture for firms with a lot of debt. For example, Hershey (HSY) has a return on equity that looks outstanding at 92%, until you realize that the company has a $3 billion debt load against just $915 million in shareholder equity!

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