Return on capital is another means of measuring a company's performance.
What Is Return on Capital?
When a company makes money, its profitability is measured in a number of ways. One of those ways is its return on capital.
Return on capital works best as a measure when used to calculate returns generated by the business operation itself, not short-term results from one-time events. Such one-time events, like gains or losses from foreign currency fluctuations, contribute to net income listed by the company, but aren't results from business operations.
A company's return on capital is an indicator of the size and strength of its ability to maintain competitive advantage over competitors to protect its long-term profits and market share from them, or its "moat."
If, for instance, a company can generate 15%-20% returns year after year, it clearly has an effective system for turning investor capital into profits.
That makes it useful as a gauge for companies that invest a lot of capital, like big box stores, computer hardware or oil and gas companies. It lets investors know if the company uses their money, a decent return can be expected on their investment.
Return on Capital Formula
(Net Income-Dividends)/(Debt+Equity)=Return on Capital.
In this way, Return on Capital is used to indicate to investors - considered capital contributors - how well the company does at turning invested capital (stockholders) and debt (bondholders) into profits.
How to Calculate Return on Capital
Here's an example: Company A has $100,000 in net income, $600,000 in total debt and $100,000 in shareholder equity. It manufactures and sells widgets.
Using the ROC formula above, we would say Company A's ($100,000 Net Income-0 Dividends) divided by ($600,000 + $100,000) = ROC.
So, Company A's ROC is 14.3%.
Let's try another example: Company B has $100,000 net income, $600,000 in total debt, and pays 25 cents a share dividends on 150,000 shares, for which it has $150,000 in shareholder equity.
Using the ROC formula above, we calculate Company B's ($100,000 net income - $37,500 in Dividends) divided by ($600,000+$150,000) = ROC.
So, Company B's ROC = 8.3%
What Can You Learn From Return on Capital?
According to a paper by Prof. Aswath Damodaran of the Stern School of Business at New York University, "The notion that the value of a business is a function of its expected cash flows is deeply engrained in finance."
In his 2007 paper, Damodaran noted that "it is only to the extent that the cash flows exceed the costs of raising capital from both debt and equity that they create value for a business. In effect, the value of a business can be simply stated as a function of the 'excess returns' that it generates from both existing and new investments."
That, in a nutshell, tells you what ROC as a measure has to offer investors and business owners.
The value of knowing or calculating Return on Capital lies also in its ability to be compared with the cost of capital.
"We can focus on just the equity invested in projects and measure the return on this equity investment; this would then have to be compared to the cost of equity," Damodaran noted in his paper. "Alternatively, we can measure the overall return earned on call capital (debt and equity) invested in an investment; this is the return on capital and can be compared to the cost of capital."
As Damodaran also noted in his paper, a company that generates higher returns on investment than it costs to raise capital for that investment "will trade at a premium over a firm that does not earn excess returns."
When, as an investor, or lender, you can calculate the return on your investment or extending credit in comparison with the cost of raising capital, you have a measure by which to compare other companies to one you're considering investing in or to which you're considering lending.
First, analysts attempt to estimate the return earned on equity, and capital "invested in the existing assets of a firm," according to Damodaran, as a place to start evaluating the quality of investments already made. "We then use these returns as a basis for forecasting returns on future investments. Both these judgments will have significant repercussions on the value that we assign a business."
So, calculating the Return on Capital helps investors and lenders get a bigger picture on the potential value of an investment or debtor, and whether money should be invested or loaned to a company or better in a bank, property, bonds or other investments or loans.
It's an even better measure by which to assess companies like big box stores, companies in oil and gas, or even computer hardware firms, that invest large amounts of capital.
Investors, and lenders, always want to know if they are getting a good return, or how to get a better return, on their investment or loan.