Understanding Return on Capital

There are two types of companies: those with high returns on capital and those without. Over time, these companies create different levels of value for their shareholders. If you're in a high-return-on-capital business, you can generate tremendous wealth as a shareholder.

What Is Capital, and How Do Companies Raise It?

Capital comes in two forms: equity investments and debt capital.

• Equity capital means giving away a portion of company ownership.

• Debt capital creates an obligation to repay it.

• There’s also preferred equity, which may convert into regular equity over time.

Why Do Companies Need Capital?

Companies require capital for:

• Working capital –  short-term liquidity to cover operational expenses

• Opex (Operating Expenses) – ongoing costs like salaries and rent.

• Capex (Capital Expenditures) – investments in assets like machinery or technology.

Some companies don’t need outside capital, while others rely on it heavily. As a shareholder, you want to own a company that doesn’t depend on outside funding.

How to Think About Return on Invested Capital

I calculate return on capital before tax, excluding goodwill and cash on hand:

ROCE formulas:

• EBIT ÷ (Net Working Capital + Net Fixed Assets)

• EBIT ÷ (Equity + Debt - Cash)

I prefer calculating after interest because interest is a real expense.

How Do Companies Increase Earnings?

To boost earnings, companies can:

• Invest in R&D, innovation, or new markets.

• Expand production capacity.

• Pay off debt to reduce interest expenses.

• Improve operational efficiency (technology, logistics, supply chain).

• Use M&A (Mergers & Acquisitions).

• Buy back shares to increase shareholder value.

But where does the capital for these investments come from? Debt, equity, or retained earnings.

Retained Earnings = Beginning RE + Net Income − Dividends Paid

Not all revenue is good revenue—if it doesn’t translate into profit, it doesn’t matter. Shareholder value is created by increasing profits, which, to me, means EBT (Earnings Before Tax).

Comparing Two Companies Based on ROCE

Imagine two companies and we assume full reinvestment of earnings for both cases.

1st Scenario

H (20% ROCE) vs. L (10% ROCE)
H trades at 15x earnings, L trades at 10x earnings.
H earns $10M EBT and has a $150M market cap.
L earns $15M EBT and has a $150M market cap.H has $50M capital employed, while L has $100M capital employed.

Year   | Capital (H1) | Earnings (H1) | Capital (L1) | Earnings (L1)  

--------------------------------------------------------------  

0      | $100M             | $20.00M          | $100M          | $10.00M  

1      | $120.00M        | $24.00M          | $110.00M     | $11.00M  

2      | $144.00M        | $28.80M          | $121.00M     | $12.10M  

3      | $172.80M        | $34.56M          | $133.10M     | $13.31M  

4      | $207.36M        | $41.47M          | $146.41M     | $14.64M  

5      | $248.83M        | $49.77M          | $161.05M     | $16.10M  

At first glance, Company L seems cheaper because of its lower valuation. Initially, it was priced at 10 times earnings, whereas H1 was at 15 times earnings. However, over five years, Company H grows at a much faster rate, leaving Company L far behind.

If you focus only on low valuation multiples as a pure value investor, you might miss this important factor. True value isn’t just about a low starting price—it comes from strong returns on capital and long-term growth.

After five years, Company L trades at 15 times its future earnings, while Company H is at just 6 times, showing the impact of reinvesting at high returns. That’s where real value is found.

🔹 Same Market Cap, Different Efficiency: Both companies have a $150M market cap, but H has $50M capital employed, while L has $100M capital employed.
🔹 H Generates Higher Returns on Capital: H earns $10M EBT (20% ROCE), while L earns $15M EBT (10% ROCE).
🔹 Compounding at Different Speeds: Over 5 years, H’s earnings grow much faster than L’s, despite L looking "cheaper" initially.
🔹 Valuation Misconception: Initially, H trades at 15x earnings vs. L at 10x earnings, making L seem like the better value.
🔹 Reality Check After 5 Years: After compounding, H trades at just 6x forward earnings, while L remains at 15x earnings—showing how reinvestment at high ROCE creates real value over time.

2nd Scenario

H2 (20% ROCE) vs. L2 (10% ROCE)
H2 trades at 10x earnings, L2 at 10x earnings.
H2 earns $20M EBT and has a $200M market cap.
L2 earns $10M EBT but has a $100M market cap.

NOTE : Both companies have $100M capital employed in this example

Year   | Capital (H1) | Earnings (H1) | Capital (L1) | Earnings (L1)  

--------------------------------------------------------------  

0      | $100M             | $20.00M          | $100M          | $10.00M  

1      | $120.00M        | $24.00M          | $110.00M     | $11.00M  

2      | $144.00M        | $28.80M          | $121.00M     | $12.10M  

3      | $172.80M        | $34.56M          | $133.10M     | $13.31M  

4      | $207.36M        | $41.47M          | $146.41M     | $14.64M  

5      | $248.83M        | $49.77M          | $161.05M     | $16.10M  

H2 compounds earnings much faster, making it a better long-term value.

Both H2 and L2 initially traded at 10x earnings, but by the end of five years, H2 will be earning close to $50 million. Looking ahead, you would be paying only 4x forward earnings for H2, making it cheaper on an absolute basis compared to L2.

Same Starting Valuation

H2 (20% ROCE) vs. L2 (10% ROCE)

🔹 Same Capital, Same P/E, Different Growth Rates: Both companies start with $100M capital employed and trade at 10x earnings.
🔹 H2 Compounds Faster: H2 earns $20M EBT (20% ROCE), while L2 earns $10M EBT (10% ROCE).
🔹 Earnings Divergence Over Time: In 5 years, H2's earnings grow to nearly $50M, while L2 reaches only $16.10M.
🔹 Valuation Becomes More Attractive for H2: Looking ahead, H2 is now trading at just 4x forward earnings, while L2 remains at 10x.
🔹 Key Takeaway: A company with high ROCE doesn’t just grow—it becomes cheaper relative to its future earnings, making it the superior long-term investment

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Final Thoughts

Just because a company looks cheap doesn’t mean it’s a good investment. A high-return-on-capital business consistently reinvests earnings, leading to compounding growth and higher long-term returns.

If you want to build wealth as a shareholder, focus on businesses that don’t rely on outside capital and have strong reinvestment opportunities.

• H1 earned $10 million and traded at 15 times earnings, creating an additional ~$200M in market cap.

• Meanwhile, L1 deteriorated $70 million in shareholder value, showing how a poor return on capital can erode long-term wealth.

There are a lot of public filings on notable value investors. For example, some of them bought Apple between 2012 and 2016 when it was trading as a value stock. They sold once it reached their estimated intrinsic value.

However, from 2017 to 2024, Apple compounded 7x, while from 2011 to 2017, it compounded 2x in five years.

• 2011-2017 CAGR: 14%

• 2018-2024 CAGR: 30%+

If you look at these cases, you can see what Charlie Munger meant by investing in high-quality companies that grow by retaining their earnings over time. Costco was one of his favorite holdings—a “forever” investment he strongly believed in.

In the case of Apple, value investors who sold it after it reached their estimated intrinsic value missed out on a ~31.4% CAGR from 2017 to 2024. This shows the power of holding great businesses for the long run rather than selling too early based on traditional valuation models.