Return on Capital vs Return on Stock

When making a decision on whether to purchase a stock you always want to be aware of how the company is investing its profits. Depending on whether it is a growth stock or an income stock, the company’s management might decide to reinvest the profits in the business (in this case an investor should expect to benefit from potential higher future returns if the business is growing) or payout dividends to the shareholders.

The role of the company managers is to effectively use the capital provided by investors (both creditors and shareholders) in order to generate additional capital in the form of profits. One of the important measures of the profitability of a company is called the Return on Capital.

Return on Capital = Profit / Invested Capital

For example, let’s assume that Company A makes a profit of $20 million this year and they had $100 million of capital to make this profit. In this case Company A would have a have a Return on Capital of 20% which is impressive. This means that for every dollar that investors put into the business, the company generates $0.20 of profit.

Now imagine that instead the company had $500 million in capital and they generated the same $20 million profit, the Return on Capital would drop down to 4% ($0.04 for every dollar invested) which is not as attractive.

While the Return on Capital provides a measure of the profitability of a company, the Return on your Stock investment refers to the total investment return for the investor. As a shareholder, your total investment return is given by your capital gain (increase in the stock price) plus any dividend payout you receive during the time you own the stock.

Return on Stock = Capital gains + Dividends

Although in the long run the performance of a stock is driven by the performance of the underlying business, it is quite common in the short run to see the stock price of a company drop even though it has a high return on capital or to see the share price increase even though it has a low profitability. This occurs because share prices reflect what the market expects. If it performs better than what investors expect, the share price will appreciate while the opposite will happen if the expectations are missed.

As Benjamin Graham once said, “A stock purchased with the hope that its price will soon rise independently of its dividend producing ability is speculation, not an investment.”

Are you chasing short term performance? If you want to maximize the long­term return on your stock investments you need to be a long­term investor.

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