Returns on incremental capital

In simple terms

A company's average return on capital tells you how its existing business has done. For judging the future, a more important question is: what return does it earn on the new money it invests?

If a company earns 25% on new investment, every rupee it reinvests adds a lot of value, and growth is welcome. If it earns 5% on new investment while its investors expect 12%, every rupee reinvested destroys value, and faster growth only makes things worse.

Estimating incremental returns

The return on incremental capital compares the change in operating profit with the change in capital employed over a period:

Use a period of several years, because new factories, stores or products take time to reach full profitability. Analysts often compare the profit change with the capital change from a year or two earlier to allow for this lag.

Reinvestment, returns and growth

How fast can a company grow its operating profit without raising new money? Roughly:

A company that reinvests half its after-tax operating profit at 20% grows profit by about 10% a year. One that reinvests all its profit at 5% grows by only 5%, and uses up all its cash to do it.

This connects three things analysts often look at separately: growth, returns on capital and free cash flow. A company with high returns on new investment can grow quickly while still producing free cash for shareholders. A company with low returns needs to reinvest almost everything just to grow slowly.

Growth and value

The key comparison is with the cost of capital, the return lenders and shareholders require, covered in the WACC lesson.

• Return on new capital above the cost of capital: growth creates value. The more the company can invest at these returns, the more valuable it becomes.
• Return equal to the cost of capital: growth neither creates nor destroys value. The company gets bigger but not more valuable per rupee invested.
• Return below the cost of capital: growth destroys value. Shareholders would be better off if the company paid out the cash instead.

This is why capital allocation, management's choices about where to invest, matters so much.

Why it matters

Markets often reward growth itself. But growth bought with low-return investment is a trap: profits rise while the value of each rupee invested falls. Incremental returns tell you whether a company's growth is the valuable kind. They also warn when a company with an excellent core business starts diversifying into weaker areas or overpaying for acquisitions.

Limitations

The estimate is rough. Changes in profit can come from pricing, the economy or cost cuts unrelated to new investment. Investment takes time to pay off, so the period and the lag you choose change the answer. Acquisitions add goodwill to capital employed, and write-downs remove it, which distorts the calculation. Use incremental returns as an indicator over several years, alongside reading what the company actually invested in.

Common mistakes

• Assuming growth always creates value. It depends on returns compared with the cost of capital.
• Assuming new investment will earn the same as the existing business. Incremental returns can be much lower.
• Measuring over a single year, before new investment has had time to pay off.
• Ignoring how the investment was funded. Growth funded by issuing shares at low prices also hurts existing owners.

Try it yourself

Pick a listed company that has grown over the last ten years.

1. From its annual reports, note EBIT and capital employed five years ago and in the latest year.
2. Calculate the return on incremental capital over the period.
3. Compare it with the company's ROCE at the start of the period.
4. Read the directors' reports for those years to see what the company invested in, and decide whether the investments explain the result.