Lesson 5 of 12 · 3 min · Valuation

Return on capital

How much profit each dollar in the business earns.

Pencil drawing of a tall stack of coins marked $100 with an arrow to a small green stack marked $15 a year.
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  1. Every business needs money put in to work: stands, lemons, fridges, cash in the till. That money is its invested capital.

  2. Return on invested capital, or ROIC, asks a simple question: for every dollar put in, how much operating profit comes out each year, after tax?

  3. Lemon Co’s $2.5 million operating profit is $1.875 million after 25% tax. The business runs on $12.5 million of capital. That is a return of 15% a year.

  4. Now picture a rival, Sour Inc, making the same profit but needing three times as much capital to do it. Its return is only 5%. Same profit, much worse business.

  5. Higher is better. As a yardstick, compare it with rivals and with what money costs the company, often somewhere around 8 to 10% a year. Earning 15% on every new stand, Lemon Co can grow and create value. At 5%, growth barely pays.

Quick question

Two companies each earn $10 million a year. One needs $50 million of capital, the other $200 million. Which is the better business?

  • The one with $50 million
  • The one with $200 million
  • They are equal
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The one with $50 million

$10M on $50M is a 20% return. $10M on $200M is only 5%. The first turns each dollar into far more profit.

Keep this one

Great businesses need little money to make a lot.

Where this comes from

ROIC here is operating profit after tax divided by equity plus net debt. Definitions vary a little between analysts. Lemon Co and Sour Inc are invented for teaching.