We received a lot of positive feedback on our recent write ups of Broadridge Financial and Sensata Technologies. We’re pleased to be building a readership of both professional investors as well as non-professionals who are interested in learning more about our investment philosophy. In writing these posts, we’re trying to strike a balance and meet the interests of both types of readers.

This post is meant as a response to two types of questions we received in relation to our recent posts: 1) Why is return on capital important and how does it relate to a company’s ability to pay out cash to shareholders? 2) Given multiple ways to calculate return on capital, what is the methodology you are using in referencing ROIC levels in your writes ups? We’ll attempt to answer those questions in order.

What is Return on Capital and Why Does it Matter?

In order to increase earnings, a company must invest in its capacity to produce goods and services. This may be buying inventory, building a new factory or installing new servers. For every dollar that is spent on these investments, an additional level of earnings can be expected in the future. For instance, a company that earns $1, uses that dollar to buy new inventory and then sells that inventory to earn $1.10 the following year has earned a “return on invested capital” (ROIC) of 10%. Not bad. This has historically been the average level of ROIC earned by public companies over the years.

Other companies can grow earnings with only small investments in their business. They may find that when they start with $1 and reinvest it, they earn $1.50 the following year. That’s a 50% ROIC. Very nice! While few companies earn this level of ROIC for very long, they do exist and are generally characterized by the company having a very strong set of competitive advantages.

The company that earns a 10% ROIC will find that in order to grow by 10% a year, they need to reinvest every dollar they earn. They won’t have any excess cash to buy back stock, pay dividends or engage in M&A. The company that earns a 50% ROIC on the other hand, only needs to reinvest $0.20 of every dollar they earn in order to grow 10%. The other $0.80 can be used to buy back stock, pay dividends or engage in M&A. If the investment opportunity is large enough, the 50% ROIC company could reinvest all of its earnings and grow by 50% a year. The 10% ROIC company, on the other hand, would have to borrow huge sums of money to grow at such a high level. Clearly, the business earning a 50% ROIC is much more valuable to its owners.

Since high ROIC businesses generate more distributable cash per dollar of earnings, their earnings are worth more and thus are assigned higher valuations (PE ratios).

This analysis is core to our investment philosophy. Far from being just an accounting formula, focusing on this metric is a primary way for business managers to grow shareholder value. One of the best explanations we’ve seen of the power of this approach for business managers came from Amazon CEO Jeff Bezos in his letter to shareholders in Amazon’s 2004 Annual Report.

How We Calculate Return on Capital

There are many different ways to calculate a company’s level of return. But from our perspective, the whole point of the calculation is to get an understanding of how much cash a company can generate as it grows. So the right way to calculate return on capital is using a methodology that gives you insight into the cash creation potential of the underlying business.

So we use the following formula:

NOPLAT/Invested Capital = ROIC

NOPLAT = net operating profit less adjusted taxes (ie the pre-tax earnings generated by the core business reduced by a “normalized” tax rate)

Invested Capital = The cumulative amount of cash a company has invested in its core operations.

It should be noted that this formula excludes non-cash assets and liabilities from invested capital. Goodwill and intangible assets tell you about the amount a company paid to acquire other companies in the past. They tell you nothing about the economics of the core business. That doesn’t mean that how much a company paid for past acquisitions doesn’t matter, just that it is not germane to the calculation of the underlying business’s ROIC.

In thinking about the future deployment of cash, it is important that analysts tease apart the cash on cash economics of the business from the capital allocation practices of the management team. If company A buys company B for a ridiculously high sum or gets it on the cheap, the cash on cash economics of company B does not change. So in modeling future cash flows, we develop a view of ROIC as defined above and then use that rate of return when thinking about cash that a company may invest in growing its business. If a company deploys its cash in other ways (paying down debt, buying back shares, paying a dividend, or engaging in M&A), we model the return on that capital differently.

For readers interested in learning the intricacies of this framework, we suggest the book Valuation: Measuring and Managing the Value of Companies, by McKinsey. While it weighs in at 811 pages, it is a surprisingly readable tour de force of the best framework we’ve come across for understanding what makes a company valuable (with ROIC being the most important driver).

At the end of the day, the most important thing is not how you define a formula but the degree to which it is useful in helping you make good decisions. We’ve found that some analysts take a sort of puritanical approach to thinking about return on capital and seem to believe that the only “correct” approach is the one that hews closest to accounting standards or results in the most depressed results. For these analysts, we’d point to Warren Buffett’s 1983 letter to shareholders in which he explained how accounting goodwill can differ so dramatically from economic reality. But before anyone gets too caught up in this debate, we’d point out that in that letter, Buffett said that while “students of investment and management should understand the nuances of the subject” he also said that “You can live a full and rewarding life without ever thinking about goodwill”!

Ensemble Capital’s clients own shares of Broadridge Financial Solutions (BR) and Sensata Technologies (ST).

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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