There are a lot of ways to calculate return on capital. Whenever, you see me use the term, it means:
Operating Income / (Total Assets – (Intangibles + Cash))
To be completely honest, I don’t look at net income. I look at operating income and I look at free cash flow. As far as I’m concerned – operating income, free cash flow, and comprehensive income make more sense than net income. But net income is the number they print in the papers. So it gets talked about.
Shouldn’t you include intangibles?
I want to know what the business naturally earns on its own assets. The book value of all assets is somewhat arbitrary. The book value of intangibles is completely arbitrary. It’s based on corporate events like acquisitions. It’s not the general manager’s responsibility. Often, the most valuable intangibles don’t appear on the balance sheet. And the least valuable intangibles appear on the balance sheet only to be written off later.
Shouldn’t you count some cash as non-surplus?
I hear people say that all the time. But it doesn’t make much sense to me. Sure, businesses usually have some cash on the balance sheet. But it’s much easier to assume that cash is always an asset apart from day-to-day operations than to try separating required cash balances from surplus cash. That’s being too clever.
If you really want to talk about surplus and non-surplus cash, that depends on cash relative to liabilities. In other words, a totally unleveraged company can always borrow money and get the “required” cash into the coffers that way. While a leveraged company can have plenty of cash on hand and yet not really be holding enough cash to pay its bills as they come due, because it’s got debt repayment to deal with too.
For me, cash should always be separated from the return on capital calculation. Cash is part of the solvency analysis. It’s not part of the business quality analysis.
And it’s easier to use just one formula. Otherwise, you get too clever and start letting your personal biases determine the right formula for every industry.
Basically, I want to start by looking at the business alone. The stuff the company actually does and the assets it actually uses. I don't want to start by worrying about whether it uses common stock, preferred stock, short-term debt, long-term debt, insurance float, whatever. I want to start with the business. Then I move on to the finances.
There is one very legitimate argument against using the return on capital formula above…
Isn’t the return on equity what really matters?
But, when I don’t know anything about a company, I always start by looking at the return on invested tangible assets. Then, if it’s a railroad, or a power company, or a water company, or a bank, or whatever – we can talk about what the appropriate leverage ratio should be.
But I like to start by looking at the actual amount earned on the tangible assets inside the business.