Return on Capital – Why ROC Matters and How It Impacts Long-Term Investment Returns

If you have been investing for some time, you must have heard of investing quotes on the importance of return on capital, like the ones below.

“What we really want to do is buy a business that’s a great business, which means that business is going to earn a high return on capital employed for a very long period of time, and where we think the management will treat us right.” – Warren Buffett

“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much difference than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.” – Charlie Munger

“A good company is one that regularly makes a high return in cash terms on capital employed, and can reinvest at least part of that cash flow in order to grow its business and compound the value of your investment. Bad companies do not do this. They make inadequate returns on the capital they employ.” – Terry Smith

So, everyone is talking about the importance of return on capital, which makes you also start believing that it is an important factor that determines your long term investment return.

To understand why high return on capital matters, read on.

Two companies with the same growth (but different ROE) – Are they the same?

Let’s discuss why high return on capital matters, using a French luxury goods company, as an example. As you can see in the chart below, Hermès has a high return on equity (ROE), of around 20% to 30%.

If you are not familiar with ROE, it is calculated as the net profit, divided by the equity amount. (There are several metrics for measuring return on capital, and today we will just talk about ROE, and discuss the difference between the various metrics in the future.)

Let’s look at how ROE affects the growth of a company, in the illustrative example below.

In 2022, Hermès earned a net profit of about EUR 3,380 million. For ease of calculations, let’s round it down to EUR 3.0 billion.

As shown in the table below (for Hermès, on the left):

• Let’s say Hermès retains 50% of the net profit in 2022, i.e. EUR 1,500 million, to spend on capital expenditure, to expand its stores and production facilities, to drive growth in 2023.

• This means that it is left with the remaining 50% of net profit, of EUR 1,500 million, which it can distribute out as dividends to shareholders.

• If Hermès generates a ROE of 30% on the incremental capital reinvested, that would translate into an incremental profit of EUR 450 million (= EUR 1,500 million incremental capital x 30% ROE) in 2023.

• This implies a profit growth in 2023 of 15% (which can also be calculated by multiplying 50% reinvestment rate, by 30% ROE).

• So, Hermès is able to generate a profit growth of 15%, but still has EUR 1,500 million of cash to distribute out as dividends (or use for buybacks).

  
  

Let’s now assume that, there is another Italian luxury company (as shown in the table above, on the right), that has the exact same net profit (i.e. EUR 3,000 million in 2022) and net profit growth in 2023 (i.e. 15%, or EUR 450 million). 

The only difference is that it has a lower ROE (on incremental capital), of 20% (which is lower than Hermès’ 30%).

So, are these two companies of the same quality? Should we as shareholders, prefer one over the other, and why so? 

All else equal, we are sure that the investors quoted above (Warren Buffett, Charlie Munger, and Terry Smith) would choose Hermès over the Italian company, every single time. Why?

Many investors like to see growth in their companies, but many tend to forget that growth is not free, that to grow a company’s earnings, the company would (likely) need to deploy more capital to generate that growth (which means less capital freely available for the shareholders).

As shown in the tables above, for the Italian company to generate the same profit growth of 15% (or EUR 450 million), it would need to reinvest EUR 2,250 million of capital, where the EUR 2,250 million, multiplied by the lower 20% ROE, leads to EUR 450 million of incremental profit.

Because the Italian company has to reinvest a higher amount of capital, of EUR 2,250 million (or 75% of the net profit in 2022), it is only left with EUR 750 million of capital (or 25% of the net profit in 2022) for dividends (or buybacks).

So, EUR 1,500 million of dividend for you from Hermès, or EUR 750 million of dividend for you from the Italian company. Which one would you choose?

Do you now see why ROE matters, even if the companies generate the same % of growth? And why do many renowned investors keep harping on return on capital?

If higher ROE is better, should we chase after the companies with the highest ROE? Or are there other considerations to take note of?

We go into more details inside our MoneyWiseSmart programs, where we look at some actual examples (of two French luxury companies) to see if a higher ROE is always better, or if there are some caveats to that.