return on equity vs. return on capital: two important indicators

In a post a few days ago, I wrote about return on equity,  which is a standard measurement of the skill of the management of a company whose stock we might consider owning.  Services like Value Line provide statistical arrays for companies–and for the industries they’re a part of–that have these calculations,and a bunch of others, already done.

Today I want to add an important refinement–return on capital.

two forms of capital

Corporations have two sources of investment capital available to them.  One is equity, which is ownership interests in the firm that the corporation sells to shareholders.  The other is debt.  Debt comes is two flavors:  bonds issued by the company or bank loans that the firm takes out.

Debt holders have a call on corporate cash that’s superior to shareholders’.  On the other hand, as creditors, debtholders have no ownership rights. So, other than if the firm is in dire financial condition, they have no say over corporate operations.

Why take on debt?

It’s easier to raise capital this way, under normal circumstances.  Also, Americans, if no one else, believe that debt is a cheaper form of capital–meaning that shareholders can gain extra return by using it.

On the other hand, financial leverage (which is what having debt is typically called on Wall Street) brings risks with it.  So it’s important for investors to distinguish in a potential investment’s returns the portion that comes from employing capital in the company and the part that comes from using debt.

where return on capital comes in

Return on capital measures the first; return on equity measures the first plus the second.  Subtracting return on capital from return on equity gives return on financial leverage (a term I made up; the number doesn’t have a common name), or return from capital structure/financial engineering.

a simple example

1.  Let’s assume that a company has 100 units of equity and that it’s in a business where investing that 100 creates 100 units of annual sales (these numbers aren’t realistic; their virtue is simplicity).

Let’s also say that the company will earn 20 units of earnings before interest and taxes (ebit) from those sales.   We’ll also say that the company pays tax at 35%.

The income statement looks like this:

sales       100

ebit          20

tax at 35%    (7)

net income       13.

return on equity =   net income ÷ shareholders’ funds   =   13   ÷    100   =  13%.

2.  Same company, but it has borrowed 100 units of debt capital @ 5% interest.

sales       200

ebit          40

debt interest    (5)

tax at 35%        (12.25)

net income      22.75

return on equity  =  22.75  ÷  100    =    22.75%.

A huge difference!!

defining return on capital

return on capital  = (net income + aftertax cost of debt)   ÷  (total capital, i.e. equity + debt)

The aftertax cost of debt:  in the US, and in many other places, interest expense is deductible from otherwise taxable income.  The tax break is:  interest expense times the tax rate.  The aftertax cost of debt is:  interest expense – the tax break.

In our case, the aftertax cost of debt is 5 -1.75, or 3.25.   Return on capital = ( 22.75  + 3.25)  ÷  200 =   13%.

results

In this example, the unleveraged company earns a return of 13% on its invested capital.  This is the return that the company’s management can achieve from operating the business.  This may be good or it may be bad   …depending on the industry and the competition.

The leveraged company produces the same return from the business.  But it amplifies this by 9.75% by using a lot of debt capital.  (By the way, the tax system encourages this behavior by allowing a writeoff of interest costs as a business expense.)

The important thing to recognize is that leverage alters the risk profile of the business, in two ways:

–the principal amount of the debt must eventually be repaid.  If the debt is a bank loan, it could be subject to a repayment demand on extremely short notice, and

–a downturn in sales will squeeze profits for the leveraged company more than for the unleveraged, since the interest expense remains a constant.  In my experience, the negative effects of leverage working against you are much more severe than this simple example suggests.

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