The Importance Of Return On Capital

A Better ROIC Formula

A truer return on invested capital formula solves these problems. It counts only assets and liabilities that are employed in generating operating earnings, and removes the rest. Non-operating costs and profits, such as interest and equity investments, are removed to get a more clear picture of the business itself. The equation for calculating traditional invested capital is:

Return on Invested Capital (ROIC) = Operating Earnings (EBIT) / Invested Capital

or Cash Return on Invested Capital (CROIC) = Free Cash Flow / Invested Capital

where...

Invested Capital = Total Assets - Current Liabilities + Short Term Debt - MAX(0; Excess Cash) - Minority Interest

Speaking of wonky!

Honestly though, it isn't that bad. We're basically taking a return on assets calculation and subtracting out:

  1. Current Liabilities, which is capital the company owes in the near term (1 year or less).
  2. Short Term Debt, which is essentially the same thing...
  3. "Excess Cash", which is cash not needed to cover current liabilities. If a firm does not have any excess cash (e.g. it is negative), we just use zero.
  4. Minority Interest, which we don't own as common shareholders.

We are left with an "invested capital" figure that best represents what capital the company has CURRENTLY employed in generating earnings and cash flow! Dividing earnings or cash flow results in a percentage that is about as close as we can get to determining how much of a return that capital is generating for shareholders.

Backing Up A Bit and Conclusion

I realize this article was a bit geeky and full of jargon. Some investors like that stuff, some don't. For those that were curious about these figures, which are used in the Magic Recipe Spell and the Quality Growth Spell, this should give some useful background.

It isn't necessary to fully understand the details of these calculations, though. The important thing is what they tell us. Good companies have business models that generate high returns on capital - or, at least, have the potential to generate high returns on capital. Poor companies with poor business models do not. It's really as simple as that!

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