Lesson 7 of 8
Incremental return on capital
A company can earn 25 percent on the capital it already has and 5 percent on everything it adds. The reported return cannot tell the two apart.
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
- Reported return on invested capital is an average over the whole balance sheet, so a falling rate on new money stays hidden while old capital dominates the base.
- The incremental return, the change in profit over the change in capital, can fall for years while the reported average still rises.
- The window can change the result as much as the tax rate or the denominator choice: three, five and ten years give materially different answers from the same filings.
A company earning 25 percent on capital it accumulated over twenty years and 5 percent on everything it reinvests today will report a high return for years, drifting down so slowly that the 5 percent stays hidden. The incremental version is the repair: the change in after-tax operating profit divided by the change in invested capital.
Reported return rising while the incremental return falls
- Reported return on invested capital
- Return on the capital added that year
Show the numbers
| Reported return on invested capital | Return on the capital added that year | |
|---|---|---|
| 1 | 8.0% | n/a |
| 2 | 13.3% | 24.0% |
| 3 | 15.0% | 20.0% |
| 4 | 15.2% | 16.0% |
| 5 | 14.7% | 12.0% |
| Year | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|
| Invested capital | 1,000 | 1,500 | 2,000 | 2,500 | 3,000 |
| After-tax operating profit | 80 | 200 | 300 | 380 | 440 |
Two questions, two numbers
In year three, the reported return is 300 divided by 2,000, or 15.0 percent. The increment is 300 less 200, divided by 2,000 less 1,500: 100 over 500, or 20.0 percent. The reported return rose for three years and fell in the fifth. The rate on new money fell four points a year from year two, so the average kept rising only because new money still earned more than the average. By year five the company reports 14.7 percent and earns 12.0 percent on new capital: both correct, and answers to different questions.
Why the window is the whole answer
Capital spent in year one does not earn in year one, so a single-year increment attributes this year's profit to this year's spending and is wrong in both directions. Over all five years the increment is 440 less 80 over 3,000 less 1,000, which is 18.0 percent: the most defensible figure in the table, and three years out of date by the time it can be computed. Three, five and ten-year windows give materially different answers for the same company, and can change the result as much as the tax rate or the denominator choice does. A second fork sits underneath: the denominator can be the change in total invested capital, or only the capital the company itself retained (earnings plus net new borrowing), and both are published under this name.
What an acquisition does to it
The acquired business is identical in both columns and earns 50 either way. The incremental return reports 10.0 percent in one case and 20.0 percent in the other, so the figure is a statement about the price paid, not about the business bought. A goodwill impairment inside the window shrinks the change in capital, so the increment across that window improves: arithmetic, not recovery. A window straddling the 2019 adoption of ASC 842 adds lease capital that was never invested in anything new.
Why a growth rate needs this figure beside it
Bruce Greenwald's argument, in Value Investing: From Graham to Buffett and Beyond, is that growth inside a competitive business earns only the cost of capital and creates nothing. He ranks growth last of the three routes to value. An incremental return near the cost of capital says growth adds nothing, however high the reported growth rate is; well above it says the growth is worth something. Buffett's 1992 letter makes the same point from the other side: growth benefits investors only when each dollar used to finance it creates more than a dollar of long-term market value, and in a low-return business that needs more capital, growth hurts the investor. His example was the airlines, where the more the industry grew, the worse it went for owners.
Compute it from two annual reports
- Take the earliest and latest of five filed years and build invested capital for each, using the lines from the previous lesson.
- Subtract the earlier profit and capital from the later, and divide the profit difference by the capital difference.
- Check Item 7 and the investing section of the cash flow statement for acquisitions inside the window.
Check yourself
A company's reported return on invested capital rises for three years. What can you conclude about the return it earns on new capital?
- It must also be rising
- Nothing on its own; the reported figure is an average that can rise while the incremental return falls
- It must be falling by the same amount
Show the answer
Answer: B.
The reported average is diluted by the accumulated base, so it can keep rising for years after the incremental rate has turned down.Why does the choice of window (three, five or ten years) matter so much for this figure?
- It does not; any window gives the same answer
- Capital spent in one year does not earn until later years, so different windows attribute profit to spending differently
- Longer windows are always more accurate
Show the answer
Answer: B.
The lag between spending and earning means the window can change the result as much as the tax rate or the denominator definition does.An identical acquired business is bought for 500 in one case and 250 in another, each earning 50. What does the incremental return measure here?
- How well the acquired business performs
- The price paid for the business, not its operating performance
- The acquirer's cost of capital
Show the answer
Answer: B.
The two columns show the same business at two prices, so the difference in the incremental figure is entirely about capital allocation.Sources
- Greenwald, Kahn, Sonkin and van Biema, Value Investing: From Graham to Buffett and Beyond, 2001, on growth ranked last of the three routes to value.
- Berkshire Hathaway shareholder letter, 1992: growth as an input to value that can be negative.
- ASC 350, Intangibles, Goodwill and Other, and ASC 842, Leases.
What this leaves out
- This page prints no level at which an incremental return becomes good; the comparison is against the company's own cost of capital, which is an estimate.
- Every increment here is computed from filed history and describes capital the company has already spent, not a forecast.
- The measure is unusable where the change in invested capital is small or negative, and it cannot be retro-tested backwards over filed history.
- Nothing here is advice about any security.