The formula (ratio) for Return on Capital (ROC) is similar to Return on Equity (ROE) but ROC takes into account long-term debt. We wrote about this HERE. A investor looking for long term investments should consider quality, as well as value measures/ratios. In order to grow and compound earnings a company must generate capital returns higher than its cost of capital. Of course, the higher the returns over the cost of capital, the better.
Return on capital provides the investor with quality measures that can be employed with many other ratios. A long term investor aims to purchase assets at a discount, but also wants to buy companies that are earning excess returns on capital. This is the only way a company can sustain an above average growth rate.
A firm’s return on capital can be an indicator of the size and strength of its health. If a company is able to generate returns of 15-20% year after year, it has a great method for transforming investor capital into profits.
Return on capital is especially useful where companies invest a large amount of capital – oil and gas firms, computer hardware companies, and even big department stores. As an investor, it’s important to know that if a company uses your money, you’ll get a respectable return on your investment.
Note – if there is NO debt, the result for ROC will be the same as return on equity (ROE), however, when there is debt, the denominator figure is larger, resulting in a lower ratio figure than the ROE.
ROC is most useful when using it to calculate the returns generated by the CORE business operation itself, not the short-lived results from one-time events. Gains/losses from foreign currency fluctuations and other one-time events contribute to the net income listed on the bottom line, but they’re not results from business operations. Try to think of what your business “does” and only consider income related to those core business operations.
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