How to Calculate Return on Capital in Investment Banking - dummies

How to Calculate Return on Capital in Investment Banking

By Matt Krantz, Robert R. Johnson

Return on capital (ROC) is an extremely important financial ratio to investment bankers. It shows investors how much of a profit the company is hauling in from the level of capital — both debt and equity — plowed into the company.

Again, if a company has access to boundless capital, it wouldn’t be surprising that the company would generate lofty returns. ROC is a ratio that attempts to quantify how skilled the management is at putting the money — both debt and equity — entrusted to it to work.

Calculating ROC takes a bit of work. The formula, in a simplified form, looks like this:

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Looks easy, right? The trouble is, it takes a couple of additional steps to derive the numerator, tax-adjusted EBIT, as well as the denominator, average capital invested in the company.

First, to get tax-adjusted EBIT, there is a shortcut: You’ll start with EBIT. You could go to all sorts of trouble adjusting EBIT for taxes, but a simple workaround used by many investment bankers is to simply multiply EBIT by 0.625. This will take EBIT down by the appropriate corporate tax rate of 37.5 percent.

Now, it’s time to get average capital invested in the company. Average capital invested in the company is a tally of all the debt and equity invested in the company. Because it’s an average, it’s generally advisable to take the capital invested in the company during the most recent 12-month period, add the capital invested in the company during the previous 12-month period, and then divide the sum by 2.

If your head is spinning on this one, don’t fret. Here is all the information you’d need to calculate Hershey’s return on capital.

Financial Measure 2012 ($ millions) 2011 ($ millions)
EBIT 1,208.32 Not needed for calculation
Total equity 1036.75 857.32
Minority interest (debt) 11.62 23.63
Short-term borrowings (debt) 118.16 42.08
Current portion of long-term debt 257.73 97.59
Long-term debt 1,530.97 1,748.50
Total capital 2,955.24 2,769.12

Source: S&P Capital IQ

Believe it or not, you have more than enough to calculate return on capital. Using the formula from earlier, you calculate return on capital as follows:

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This tells you that Hershey generated a 26.4 percent return from the assets invested in it. Not too shabby.

As is the case with most of the financial ratios, the real analysis by investment bankers is done by comparing the ROC from a prior period — say, 2011 in this example — or against the ROC of another company in the industry. It’s also important to note that most of the systems that investment bankers use — such as Bloomberg, S&P Capital IQ, and Thomson-Reuters — can calculate ROC.