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The Theory Behind Return on Capital and Return on Equity (in the context of value investing)

What does it mean when a company says it earned $1 million dollars last year? A corporation's earnings, or net income, roughly estimates the amount of cash it would generate if the company was not growing. For example, suppose Jack owns a chain of 20 lemondate stands known as "The Jack Company", and suppose this business earned $10,000 last year. As long as Jack doesn't grow his business, the business should generate approximately $10,000 in cash each year, which could, for example, be paid to the company's shareholders in the form of a dividend.

However, suppose Jack wants to grow his business. He finds that, for $5000, he can build two more lemonade stands. If he has 22 lemonade stands instead of 20, his yearly income will rise from $10,000 to $11,000. So, his $5000 investment will increase his income by $1000 per year. The return on his investment is $1000/$5000, which is 20%. And, if Jack has gotten a 20% return on everything he has invested in the business, we say that the business is earning a 20% return on invested capital. That's a pretty good return.

Although Jack's net income was $10,000, he reinvested $5000 of that income in his business; thus, the business only earned $5000 in cash.($10,000 - $5000 = $5000) $5000 was the company's Free Cash Flow.

It turns out that Jack's friend Jill also owns a chain of 20 lemonade stands. Like the Jack Company, the Jill Company earned $10,000 last year. Jill decides that she wants to expand her business; she wants 22 lemonade stands instead of 20. She, however, lives in San Francisco, where property prices are extremely high. The Jill Company will have to spend $20,000 to build those two lemonade stands. Once she builds the stands, she will also have $11,000 in net income, or an additional $1000 in income per year. However, Jill must spend $20,000 to earn that extra $1000 per year. The return on the Jill Company's investment is only $1000/$20,000, or 5%. Jill had to spend an extra $15,000 to get that same $1000 in additional earnings. The Jill Co's free cash flow will be ($10,000 - $20,000), which comes out to a loss of $10,000 per year. If Jack and Jill build two lemonde stands every year, The Jill Co will spend an additional $15,000 every single year! Eventually, of course, the Jill Co will run out of money and will be forced to stop expanding. The Jack Co, however, will continue to build two lemonade stands every single year, and even more impressive, it will earn boatloads of cash in the process!

Return on Equity is similar to return on capital. A company's Return on Equity is equal to its income divided by the net value of its assets. The formula is:

Net Income
_____________________________
(Total Assets - Total Liabilities)

Thus, a company's return on equity is the rate of return it earns on every dollar that has been put into the business.

Now that we have defined return on equity, we can use it to predict just how much cash a business will bring in every year. We can predict that the free cash flow of a business will be roughly equal to:

Net Income X (Return on Equity - Growth Rate)
_______________________________________________
(Return on Equity)

Looking at The Jack Co, we get:

$10,000 X (20% - 10%)
_______________________________________________
(20%)

which is equal to $5000.

For The Jill Co, we get

10,000 X (5% - 10%)
_______________________________________________
(5%)

which is equal to -$10,000.

We previously mentioned Return on Capital, and this actually very similar to Return on Equity. A company's return on capital is what its return on equity would be if the company had no debt; it is an estimate of the returns that a company gets on the capital that it invests in the business.

However, if a company borrows money, its Return on Equity will should be higher than its Return on Capital, and here's why:

Suppose the Jack Co owns 20 lemonade stands, whose assets are worth $50,000. The company also produces $10,000 in annual income. Suppose the company pays its $10,000 in income as a dividend, and then borrows $5,000 at an interest rate of 6%. This means that the company will pay an additional $300 in interest ($5,000 * 6% is $300). However, since the company was able to build 20 lemonade stands with $50,000, it costs about $2500 for Jack to build a stand, and the $5000 can buy two new stands. And these two lemonade stands will generate $1000 in income ($5000 worth of lemonade stands * a 20% return on invested capital = $1000 in additional income). So, the company is gaining $700 in annual income ($1000 - $300 = $700) by borrowing $5000 in debt. The company's asset base is still $50,000, but its income has increased to $10,700. Thus, even though the company is still only earning a 20% return on the cash it invested in its business, its return on equity is $10,700/$50,000 which is 21.4%. In fact, the Jack Co could, in theory, borrow $50,000 and pay it out as a dividend. It would then be earning $10,000 before interest and paying $3,000 in interest, for a net profit of $7,000. The company's equity would then be 0, so its return on equity would be infinite.

So, why don't companies take on as much debt as they can? For one thing, debt can be risky. If a company takes on a lot of debt, its potential downside will be magnified. A downturn in sales could cripple the company, or even force it to file for bankruptcy. Furthermore, it is often important for companies to maintain a high Credit Rating.