Return on Capital – Calculations & Ratios

by | Investment Analysis

Return on Capital

Return on Capital

Return on Capital Calculations and Ratios provide measures of quality for the value analyst searching for long term investments.

Investors who choose to look for more than just value need metrics with which to search for companies that deliver excess returns on capital. Without such metrics the value investor should concentrate only on purchasing investments at a deep discount and selling them when they approach intrinsic value .

A long term investor (i.e. Warren Buffett) not only aspires to purchase assets at a discount, but attempts to buy companies that are earning excess returns. This is the only way a company can sustain an above average growth rate.

Notes on Return on Capital (ROC)

There are no standard formulas for these ratios. Be careful when exploring on the internet. I found many different formulas, some of them variations that made sense, and some that were just plain incorrect.

If you really want to dig deeply into the subject I recommend ROC, ROIC, and ROE: Mearsurement and Implications, by Aswath Damodaran.  The professor’s paper takes the subject much further and in-depth than I can here.

These are ROC ratios and calculations that analysts use to determine which companies have the potential to be long term holdings:

1. Return on Invested Capital (ROIC)

The ROIC ratio measures the return achieved on equity and debt capital invested by the entity. For value investors looking for quality this is one the most popular and valuable metrics:

Return on Invested Capital (ROIC) =  Net Operating Profit After Taxes (NOPAT) /  Book Value of Invested Capital


Net Operating Profit After Tax (NOPAT) = Net Profit After Tax + After Tax Interest Expense – After Tax Interest Income + Goodwill Amortization (if any)

(Note: NOPAT is equal to Net Income for companies with no debt and interest expense. In other words, NOPAT is the amount that that would flow to shareholders if the company is debt free and therefore has no interest.)

Invested Capital = Current and Non-Current Portion of Debt (Total Long Term Debt) + Shareholders Equity + Minority Interests  (Y-Charts definition)

(Note: There is no standard formula for Invested Capital. I am using Y-Charts definition throughout the post because I use it and think it’s a good measurement.)


Since Operating Profit and EBIT are the same you can figure ROIC with EBIT after making an adjustment for taxes:

Return on Invested Capital (ROIC) = EBIT (1 – tax rate) / Investing Capital


EBIT =  Earnings Before Interest & Taxes

(1 – tax rate) =  This is a theoretical estimate of the effective or marginal tax rate. This adjusts EBIT to an after tax estimate.

Invested Capital = Current and Non-Current Portion of Debt (Total Long Term Debt) + Shareholders Equity + Minority Interests  (Y-Charts definition)

Return on Invested Capital (ROIC) Calculator


2. Cash Return on Invested Capital (CROIC)

CROIC is related to ROIC with a slight alteration. The numerator is Free Cash Flow (FCF) instead of Net Income. Some investors replace Free Cash Flow with Warren Buffet’s metric Owner Earnings since they are similar:

Cash Return on Invested Capital (CROIC) = FCF / Invested Capital


Free Cash Flow (FCF) = Operating Cash Flow (OCF) – Capital Expenditures

Invested Capital = Current and Non-Current Portion of Debt (Total Long Term Debt) + Shareholders Equity + Minority Interests (Y-Charts definition)

CROIC tells you how much free cash flow the company is generating for every dollar invested in capital.

3. Magic Formula Return on Capital

Joel Greenblatt made the Magic Formula famous in his book “The Little Book That Beats the Market” (Amazon Link).  Greenblatt’s formula combined a price ratio with a quality ratio to produce the “Magic Formula. The quality half of the ratio is:

Magic Formula Return on Capital = EBIT / (Net Fixed Assets + Working Capital)


EBIT = Earnings Before Interest & Taxes

Net Fixed Assets = Property, Plant & Equipment – Depreciation & Amortization

Net Working Capital = Current Assets – Current Liabilities

I find it interesting that Tobias Carlisle’s research on the Magic Formula found that the price half of the formula is extremely proficient at finding value investments. However, he found that the quality half (return on capital) did not provide any benefit to the consistency of the findings.  You can find his analysis in Deep Value: Why Activist Investors and Other Contrarians Battle For Control of “Losing” Corporations (Amazon Link) Pg. 54 – 69.

4. Return on Capital Employed (ROCE)

Again, there is no set formula for ROCE. You will find several different descriptions if you do an internet search. I am using the definition used by Y-Charts:

Return on Capital Employed (ROCE) = EBIT / Capital Employed


EBIT = Earnings Before Interest & Taxes

Capital Employed = Total Assets – Current Liabilities

A more accurate version of ROCE is:

5. Return on Average Capital Employed

The following is the Y-Charts definition of ROCE, but it is actually :

Return on Average Capital Employed (ROACE) = EBIT / Average Capital Employed


EBIT = Earnings Before Interest & Taxes (EBIT)

Capital Employed = Average Total Assets (Annual) – Average Total Current Liabilities (Annual)

For most investors it would be sufficient to use: Capital Employed = Total Assets – Current Liabilities (instead of average). This makes the calculation easy if you are not using Y-Charts.

Return on Capital Employed (ROCE) Calculator

(Note: One downfall of ROCE is that it does not deal with the fact that depreciation and amortization will be different for every entity. Therefore companies with heavily depreciated assets may have their ROCE increase without an actual increase in profits.)

Capital Returns and Quality

A value investor looking for long term holdings must consider quality metrics as well as value metrics. 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 the better.

Return on capital ratios provide the value investor with quality metrics that can be employed after, or along side, valuation metrics. This allows the long term investor to look for “wonderful companies at a fair price” (Warren Buffett).

Related Reading: Return on Total Assets – Ratios & Calculations

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