Return on capital

Chapter 8 said margin is half a sentence. This is the other half, and together they are the most useful judgement you can form about a business from its accounts.

The question

A company earned ₹100 crore. Good? It depends entirely on what was tied up to produce it. ₹100 crore on ₹400 crore of capital is a fine business. ₹100 crore on ₹4,000 crore is a poor one.

Return on capital is profit divided by the money invested to generate it, and it is the closest thing in this subject to a single verdict.

The two measures

Return on equity (ROE) = net profit ÷ shareholders' equity.

What shareholders earned on what belongs to them. Direct, and distorted by one thing: borrowing. A company can lift ROE by taking on debt without improving its business at all, because the same profit sits on a smaller equity base. Chapter 10 pulls that apart.

Return on capital employed (ROCE) = operating profit ÷ capital employed, where capital employed is equity plus borrowings (or total assets less current liabilities).

What the business earns on all the money in it, lenders' and owners' alike. Because it uses operating profit and total capital, it is indifferent to how the company is financed — which makes it the better measure of the business itself, and the one to use when comparing two companies.

Use ROCE to judge the business. Use ROE to judge what owners got. The gap between them is chapter 12's leverage.

What a high return actually means

A company earning 25% on its capital year after year is telling you something important: competitors have not taken it away.

In an ordinary market, high returns attract entrants until returns fall to the cost of capital. A business that sustains high returns for a decade has something stopping that — a brand, a network, a cost advantage, a licence, switching costs. Whatever it is, the sustained return is the evidence of it, which is why this number carries more weight than almost any other.

The corollary is uncomfortable and worth saying. A company earning 7% on capital when capital costs it 11% is destroying value while reporting a profit. It is profitable in accounting terms and shrinking the owners' wealth, and growth makes it worse rather than better — because every rupee of growth is reinvested at a return below its cost.

That is the single most useful idea in this chapter: growth is only good when returns exceed the cost of capital. Otherwise growth is an expensive way to get smaller.

Reading it properly

Four cautions, each of which changes the number materially.

Use an average. Profit is a period and capital is a date. Use the average of opening and closing capital, or a high-growth company's return looks worse than it is.

Watch the cash. A company with a huge cash pile shows depressed ROCE because the cash sits in the denominator earning little. Returns excluding surplus cash describe the operating business better — and whether the company should still be holding that cash is a separate and legitimate question.

Goodwill matters. Chapter 5: an acquisitive company carries goodwill in capital employed. Excluding it flatters, and including it is the honest measure of whether the acquisitions earned their price. Look at both — the difference tells you what the deals cost.

One year proves nothing. Returns swing with the cycle. Five years, through a bad one, is the test.

Where high returns come from

Chapter 10 decomposes this formally. Informally, two routes:

High margin. Each sale is very profitable. Branded goods, software, specialised products.

High turnover. Each rupee of capital produces many rupees of sales. Retail, distribution, asset-light services.

Both produce good returns. Businesses that manage both are rare and usually expensive. Businesses with neither are the ones to understand before buying — sometimes the industry is simply like that, which is a reason to expect modest returns rather than a reason to expect improvement.

The connection to the share price

Chapter 2 of the equity subject said the durable source of return is earnings growth. This chapter explains what makes earnings growth durable.

A company earning high returns can reinvest its profits at those returns and compound. A company earning low returns cannot — its growth consumes cash and produces little. Two companies growing earnings 15% a year are completely different investments if one funds it from a 25% return and the other from an 8% return plus borrowing.

That difference does not appear in the growth rate. It appears here.

The point

ROCE is operating profit over all the capital in the business and judges the business; ROE is net profit over equity and is flattered by debt. A sustained high return is evidence that something protects it. Growth only creates value when returns exceed the cost of capital — below it, growth destroys value faster.