Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Return on Capital

What it is:

Return on capital is a profitability ratio. It measures the return that an investment generates for capital contributors, i.e. bondholders and stockholders. Return on capital indicates how effective a company is at turning capital into profits.

How it works (Example):

The general equation for return on capital is: (Net income - Dividends) / (Debt + Equity)

Return on capital is also known as "return on invested capital (ROIC)" or "return on total capital."

For example, Manufacturing Company MM has $100,000 in net income, $500,000 in total debt and $100,000 in shareholder equity. Its operations are simple -- MM makes and sells widgets.

We can calculate MM's return on capital using the above equation: 

(Net income - Dividends) / (Debt + Equity) = (100,000 - 0) / (500,000 + 100,000) = 16.7%

Note that for some companies, net income may not be the best profitability measure to use. You want to make sure that the profit metric you put in the numerator provides a genuine measure of profitability.

Return on capital is most useful when you're using it to calculate the returns generated exclusively by the business operation itself, not the short-lived results from one-time events. Gains/losses from foreign currency fluctuations and other one-time events contribute to the net income listed on the bottom line, but they're not results from business operations. Try to think of what your business "does" and only consider income related to those core business operations.

For example, Conglomerate CC lists $100,000 as net income, $500,000 in total debt and $100,000 in shareholder equity. But when you look at CC's income statement, you notice a lot of extra line-items, like "gains from foreign currency transactions" and "gains from one-time transactions."

In the case of CC, if you use the net income number, you are not being very specific as to where the returns are being generated. Were they from strong business results? Were they from fluctuations in the foreign currency markets? Did CC sell a subsidiary?

For CC, it makes more sense to use an income measure called net operating profits after tax (NOPAT) as the numerator. It's not found on the income statement, but you can calculate it yourself using the following equation:

NOPAT = Earnings before Interest & Taxes * (1 - Tax Rate)

Using NOPAT in the equation will tell you the return the company generated with its core business operations for both its bondholders and stockholders.

Why it Matters:

A firm's return on capital can be an excellent indicator of the size and strength of its moat. If a company is able to generate returns of 15-20% year after year, it has a great system for transforming investor capital into profits.

Return on capital is especially useful for companies that invest a large amount of capital, like oil and gas firms, computer hardware companies, and even big box stores. As an investor, it's imperative to know that if a company uses your money, you'll get a respectable return on your investment.

Related Terms View All
  • Auction Market
    Though most of the trading is done via computer, auction markets can also be operated via...
  • Best Execution
    Let's assume you place an order to buy 100 shares of Company XYZ stock. The current quote...
  • Book-Entry Savings Bond
    Savings bonds are bonds issued by the U.S. government at face values ranging from $50 to...
  • Break-Even Point
    The basic idea behind break-even point is to calculate the point at which revenues begin...
  • Calendar Year
    If Company XYZ starts its fiscal year on January 1 and ends its fiscal year on December...