Profitability - Part II

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Profitability is critical for a company's survival and growth. It enables businesses to reinvest in operations, pay dividends to shareholders, and withstand economic downturns. We first discuss margins, but margins alone do not provide a complete picture of a company's profitability. For instance, a company may have high margins but inefficient capital allocation, which can hinder long-term growth. This is where rate of returns come into play.

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We are a bit more demanding than simply requiring a company to cover its costs as we usually like companies making a lot of money for every dollar they invest. How do we measure that? We typically look at three measurements, ROIC (or Return on Invested Capital) and ROCE (or Return on Capital Employed), and ROC (Return on Capital), which are defined as:

On the other hand, ROC is a variant of ROCE from Joel Greenblatt, calculated using at the denominator instead of Capital Employed, the Net Fixed Assets and Net Working Capital, which together we may call Net Capital Employed. Joel Greenblatt is an academic and fund manager who wrote “The Little Book That Beats the Market”. In this book he introduced the investment strategy of "magic formula investing", a method for determining which stocks to buy: cheap and good companies with a high earnings yield and a high Return on Capital. At Gotham Capital between 1985 and 1994, Greenblatt presided over an annualized return of 50% "after all expenses".

Before being able to calculate the above we need just a few definitions:

Working Capital = Total Current Assets – Total Current Liabilities

If Cash, Cash Equivalents, Marketable Securities > Working Capital then Excess Cash is equal to Working Capital; otherwise to Cash, Cash Equivalents, Marketable Securities.  We can then calculate the Invested Capital as:

Invested Capital = Total Assets – Accounts Payable & Accrued Expense – Excess Cash.

Accounts Payable is usually easy to retrieve in the financial statements, while Accrued Expenses need to be searched for. Similarly, there is no clear-cut definition of Excess Cash. On the other hand, it seems there is consensus on the definition of Capital Employed, which is:

Capital Employed = Total Assets – Total Current Liabilities = Non-Current Assets + Working Capital

Finally, for ROC purposes, we calculate the Net Capital Employed as:

Net Capital Employed = Net Fixed Assets + Net Working Capital

The main difference between ROCE and ROC is that the latter only focuses on Net Fixed Assets (which in the financial statements is often referred as “Property, plant and equipment, net”) and Net Working Capital, which is in turn defined as:

Net Working Capital = max[(Accounts Receivable + Inventory + Other Current Assets) – (Accounts Payable + Other Current Liabilities); 0].

Finally, considering that capital allocation may impact the result given the month of the investment, to smoothen this effect we usually take the average of the last two years when calculating the Invested Capital, Capital Employed, and Net Capital Employed.

From the previous example at Apple in Profitability - Part I, we can find that in 2024 NOPAT were equal to $123,216 * (1 – 24.1%) = $93,521.

where Accrued Expense is income tax payable at page 29 of Apple’s Annual Report.

From the formulas above, we can easily calculate the following:

• ROIC = $93,521 / $292,824 = 31.94 %.

• ROCE = $123,216 / $188,588 = 65.34%.

• ROC = $123,216 / $44,697.5 = 275.67%.

As a rule of thumb we like ROIC >15% and ROCE, ROC > 20%, but the higher usually the better. Oversimplifying this means that for every dollar invested by the management of the company they will be able to generate at least fifteen / twenty cents a year.

From this example it should be clear what we meant in our last article “Understanding the Business”: unfortunately one cannot blindly trust third-party’s calculation as even the calculation of ratios (which is fairly quantitative) still has a degree of freedom when deciding how to classify certain variables. For instance, here we had to recognise that Income Tax Payable at page 29 should be categorise as Accrued Expense. Therefore, we strongly recommend that you go through all these calculations to make sure that you are get confident with these passages.