Lesson 5 of 5
The hurdle rate test
A return on capital is not a result until it is set beside what the capital cost. Mixing a before-tax return with an after-tax cost overstates it.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A return on capital only means something once it is set beside what that capital cost.
- Comparing an untaxed return with an after-tax cost of capital overstates the gap between them, sometimes by several points.
- A spread near zero has not been shown to be positive: it sits inside the error of the cost-of-capital estimate.
Above the cost of capital, reinvested capital adds value and growth is worth having. Below it, growth destroys value, and the faster a company grows the more it destroys. Buffett made the point in the 1992 letter: growth is an input to value, not an alternative to it, and its contribution can be negative.
Where an 8% cost of capital sits among US after-tax returns on capital
An illustrative cost of capital, 8%: between the median (3.43%) and the 75th percentile (11.23%).As a floor it admits between a quarter and a half of the cohort.
- 10th percentile: −97.62%
- 25th percentile: −21.73%
- median: 3.43%
- 75th percentile: 11.23%
- 90th percentile: 22.47%
Tax both sides the same way
The most common way to get this comparison wrong is not the cost-of-capital estimate. It is arithmetic. A WACC is already after tax on the debt side, so the return has to be after-tax operating profit to match it. Leave the return untaxed and the spread is overstated by the tax on that profit, every time.
An average return, a decision about the next unit
The reported return divides one year of profit by the capital on the balance sheet, most of it invested years ago. The decision this comparison exists to inform is about the next unit of capital, which is a different question. A company earning a high return on a mature core and a low return on what it currently reinvests can report a wide, comfortable spread for years while its forward rate is already falling. The reported figure alone does not disclose the mix.
A close call is not evidence
The cost side of this comparison rests on two other estimates: a beta with several defensible measurements, and a premium nobody can observe. Those uncertainties do not cancel; they stack. A spread near zero has not been shown to be positive, and treating a fraction of a point as a finding reads precision into a number that has none. The comparison says something only when the gap is wide enough that no defensible beta or premium could close it.
Where the test does not apply
For a bank, deposits and borrowing are raw material it earns a spread on, not financing, so operating and financing cannot be separated and invested capital has no clean definition. A bank is read on return on equity against the cost of equity instead. Insurers, capital markets firms and mortgage REITs each fail the comparison in their own way, which is why the cohort above excludes them rather than forcing a number through.
Check yourself
A company's WACC is computed after tax on the debt side. What must the return side use to match it?
- Operating profit before tax
- After-tax operating profit
- Revenue
Show the answer
Answer: B.
Both sides of the comparison need to be measured the same way. Leaving the return untaxed compares an after-tax cost with an untaxed benefit.In the worked example, the after-tax spread is 7.20 points. What happens if the return is left at its before-tax figure instead?
- The spread falls to 4.20 points
- The spread stays at 7.20 points
- The spread rises to 12.20 points, overstating it by 5.00 points
Show the answer
Answer: C.
The tax on the operating profit, 50 over 1,000 of capital, is exactly the 5.00 point gap between the two spreads.Why is this spread withheld rather than computed for a bank?
- Banks never earn a positive return on capital
- A bank's borrowing is part of its operations, so invested capital cannot be separated out
- Banks are outside the US market this product covers
Show the answer
Answer: B.
Deposits are the bank's raw material, not its financing. The comparison is made at the equity level instead.Sources
- Berkshire Hathaway shareholder letter, 1992: growth and value joined together, and growth's contribution can be negative.
- Mauboussin and Callahan, "The Math of Value and Growth", 2020: growth adds value only when returns beat the cost of capital.
- Damodaran, Investment Valuation and The Dark Side of Valuation: the return against cost-of-capital comparison as a test of value creation.
- Penman, Financial Statement Analysis and Security Valuation: reformulating the statements so a return and its cost are measured on the same capital base.
What this leaves out
- The cohort figures were computed on 2026-09-07 and are rebuilt on a schedule, so a later reader will see different breakpoints.
- The worked example uses round invented inputs so the arithmetic can be checked by hand, and isolates one effect: the tax basis.
- Return on invested capital cannot be retro-tested against a company's own filed history in this product today.
- A positive spread describes the period measured. It does not say the next period will look like it. Nothing here is advice about any security.