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What's Wrong With Return On Capital


Return on capital is expressed in a variety of ways--ROI, ROA, RONA, ROC, ROCE, etc. But all of these return metrics presume that higher returns are better.

For ROI, which is usually applied to a single investment, that assumption is usually true. But for the other return measures, as they are generally applied to whole businesses comprised of many overlapping investments of different scale, timing, and risk, it may not be true.

This can be easily illustrated by a company that currently has a 17 percent ROC, and a choice of committing new capital to either building a warehouse or investing in a sophisticated logistics system (one that foregoes the need for a warehouse). These are mutually exclusive, different sized bets that have the following investment and return characteristics:

Warehouse: Invest $1 million for a 20 percent annual return

Logistics system: Invest $3 million for a 15 percent annual return

If the returns materialize as projected, the the warehouse would have the effect of increasing the company's overall ROC, while the logistics system would have the effect of diluting it. But if the company has access to additional capital, investment in the logistics system is likely to create more value for the shareholders.

What Return on Capital misses (Part 1)

Return on capital must be compared to the cost of capital in order for us to determine how much value an investment creates. In this example, as long as the cost of capital was less than 15%, either investment would create value.

Furthermore, we can determine that the logistics system creates more value than the warehouse if the company's cost of capital is below 12.5%. For example, if the cost of capital were 10 percent, the warehouse would yield a return of $100,000 in excess of the cost of capital ($1M x [20% - 10%]), while the logistics system would yield a $150,000 return ($3M x [15% - 10%])

What Return on Capital misses (Part 2)

Our example illustrates that the scale of projects also matter. If the company is not capital constrained, then the level of investment is a key input in figuring out how much value is being created and, therefore, which investments to make.

Most companies have a wide array of possible strategies that they can pursue over an indefinite life. Investments can be made from issued or borrowed money or, as the company matures, from funds generated by previous investments.

What Return on Capital misses (Part 3)

Furthermore, while ROI may account for risk in discrete investments, overall returns on capital do not account for risk at all. For instance, an agricultural firm might increase its use of derivatives, which could increase or decrease overall firm risk depending on whether the derivatives were used to hedge or leverage exposure to their product prices.

In other words, most companies have no meaningful constraints with regards to either timing, exclusivity, scale, or risk of their investments. Therefore, even if you are tracking ROC relative to cost of capital, and trying to make that spread as wide as possible, you may still be driving sub-optimal business decisions that compromise value creation.

When it works

If you happen to be operating a business where you have a fixed pool of capital, and one chance to invest it, scale is an irrelevant consideration because it is exactly the same across all possible strategies. Risk may not be a relevant consideration if your investments are constrained by your business model, or if it is otherwise well understood by your investors.

Certain closed-end funds or family offices look might like this, especially on a year-over-year basis. In this case, the percentage return on that relatively fixed capital will be a reasonable proxy for value creation.


© 2015 by Hodak Value Advisors.