Increasing Return on Capital

Increasing return on capital (assets) is directly related to increasing net income while maintaining a stable asset base. There are two ways this is accomplished:

1. Increase the revenues the assets generate (Asset Turnover), or

2. Increase profit margins on the existing revenues. (Cost characteristics)

Why is this important? Increasing returns, in general, are important for value creation, and is a major difference between equity in a company and a bond. Companies are valued like bonds, but cash flows (or perception of cash flows) are constantly changing which creates volatility. Increases in return on operational assets over time is like a bond that continually increases coupon payments. That bond price would continually rise (as does a stock price).

See these principles apply to valuing a company by visiting our how guide here: Link

Examples of Increasing Return on Capital

A company increases return on tangible assets by increasing income (cash) more than tangible assets. (increasing the numerator faster than the denominator). Here are ways a company accomplishes this:

1. Increase Revenue: A company does this by selling more products or services and/or raising prices with the same asset base. (Asset Turnover)

   • The most common way to increase revenue is to increase the price of goods or services. A company with a great economic moat can essentially increase prices at or slightly above inflation every year. If inflation is 2%, a company rises prices by 3% and thus creates a higher asset turnover ratio. A company grows indefinitely without growing volume in this case.

   • A company increases revenue through improved asset utilization. For example, it

     • improves its production process to increase efficiency: This naturally happens over time with increases in energy efficiency, human machine interface improvements, and operational efficiency gains.

     • utilizes its assets for longer periods of time: A trucking company with superior upkeep can extend life of assets past the depreciation timeline and thus generate revenue with assets fully depreciated. (no depreciation cost and minimal capital expenditure)

     • rents out idle assets: This is self explanatory. If a company has assets not in use, the immediate production will increase revenue (and variable costs) with the same asset base. The investor will most commonly see this in cyclicals (like steel).

   • Some companies have revenue streams that are naturally more scalable than others and thus can increase return on assets. For example, a lawn mowing company is less scalable than a manufacturing company and a software company is more scalable than a manufacturing company. Read why revenue matters here.

2. Increase Income Margins

   • Reduce expenses: This is achieved through cost-cutting measures like reducing staff, cutting unnecessary expenses, or negotiating better deals with suppliers.

   • Optimize the asset mix: This means investing in assets that generate higher returns or divesting assets that are not performing well.

   • Implement better asset management practices: Effective asset management practices, such as proper maintenance and replacement of equipment, can help increase the lifespan of assets and reduce the need for new investments.

Using this Information

Understanding sales turnover and margins is crucial when looking for investable companies. Look for companies that have economics to increase one or both of these metrics. There are essentially two paths the investor can take with this information.

1. Look for current market leaders with high return on net tangible assets (over 20%). The investor then should anticipate a growth rate similar to the overall market plus a healthy dividend increased over time.

2. Look for growing companies with economics to grow return on assets. Software, consumer brands, non-price-controlled government regulation are all great examples of companies that tend to increase returns on assets over time.

Summary

When searching for companies to invest in, the revenue and business model is important. There needs to be a reasonable probability that a company will maintain and possibly grow in value. Return on tangible assets and the growth in that return is a major piece of determining that probability. Company’s with scalable business models, viable business models, and strong branding can accomplish this. To see a full detail of the research process, visit our article here: Researching a Business