Although many investors are familiar and comfortable with traditional valuation parameters such as earnings per share (EPS) and return on equity (ROE), these tools may only provide a partially accurate picture of a company’s value. Investors may want to familiarize themselves with another measurement called “incremental return on capital.”
Incremental return on capital is a rather interesting figure. Distillation of its meaning essentially leaves you with this definition; a method to assess the return on capital earned on new investments or new dollars. It is a forward leaning analysis of what will likely to occur, based on what has most recently occurred. In many ways this figure is an assumption, a type of financial inertia put in motion by previous investment returns or efficiencies.
Traditional Valuation Metrics - A Partial View
EPS is calculated by subtracting dividends on preferred stock from net income, and dividing that figure by the number of outstanding shares. But EPS isn’t always a good gauge of a company’s value because it can be manipulated by accounting practices, as many corporate blowups of the past decade (Enron) taught us.
So, many investors also look at ROE, which is a company’s net income divided by its shareholder’s equity. This figure shows how much profit a company generates with the money shareholders have invested. For example, a company with a 10% return on capital earns 10 cents for every dollar invested. (One quick side note: A similar figure, return on invested capital, or ROIC, is also often used. ROIC is calculated by dividing a company’s net income by its capital, which is simply its shareholder’s equity plus long-term debt. We won’t debate the pros and cons of these two figures here, but simply say that for the purposes of our discussion, they are the same).
ROE and ROIC can help investors compare the profitability of a company to that of other companies in the same industry, so it’s certainly valuable. But, it is not without problems. Specifically, ROE and ROIC both measure how productive each dollar of equity invested in a company is in aggregate, meaning all of the company’s businesses over a wide time period.
What’s wrong with that? The primary problem with these figures is that they can mask a company’s more recent performance, which is often important. Some companies perform consistently year after year, but others perform well for years then falter for any number of reasons. While sometimes those reasons may be surmountable (such as a bad CEO who was replaced or a temporary production problem), other times they may be serious (such as a quality problem or a product no one wants to buy). If a company’s recent problems are serious, you probably don’t want to buy its stock, regardless of the company’s past performance—but you might end up doing so if the only figure you look at is ROE or ROIC.
Incremental Return on Capital – A Fuller Monty
That’s why another figure, incremental return on equity or incremental return on capital, is important. Like ROE and ROIC, these numbers are similar, but for the purposes of our discussion, let’s focus on incremental return on capital. Incremental return on capital looks at a company’s recent performance, not its aggregate performance. Wal-Mart Stores is a good example of the discrepancy between ROE or ROIC and incremental return on capital. In the early 1990s, Wal-Mart’s EPS showed that its earnings were growing at a fast clip (double digits, in fact), and its ROE/ROIC was solid. At the same time, its incremental return on capital was falling, from 25% in 1990 to 7% in 1995. In other words, for each dollar someone invested in the company, he or she got back not 25 cents, but seven cents. That’s a steep difference.
Essentially, Wal-Mart had the same problem as a baseball player whose batting average drops, dragging down his lifetime average. Perhaps at one time the player was great—but he’s not anymore. Would you keep him on the team? Investors didn’t keep Wal-Mart on their “team”; the stock lagged the market during the early 1990’s.
Who Uses Incremental Return on Capital?
Many value investors, who seeks stocks that are temporarily “on sale,” are advocates of incremental return on capital as a measure of a company’s valuation.
"Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return,” noted value investor Warren Buffett once said. Buffett concluded, “The worst business to own is one that must, or will, do the opposite—that is, consistently employ ever-greater amounts of capital at very low rates of return."
Keep in mind, however, that just as other measures of valuation can’t show the full picture of a company’s value, incremental return on capital also has its limitations, and is best used as part of a comprehensive valuation system.