Focus on Return on Capital Employed
The single most important indicator of the inherent excellence of a
business is the return on capital employed. Youve heard the statement,
it takes money to make money. Those that understand compounding know
that the goal is to make as much money with as little invested as
possible while avoiding the dangers of leverage.
Think of it this way: It may take a steel mill $100 in assets to earn
$1 due to the large facilities it must build, the shipping costs of
moving its product, etc., while it may take a luxury candle maker only
$1.50 in invested assets to generate that same $1 profit. The owner of
the candle company could drain the business and reinvest the profit
elsewhere without damaging the profitability of the enterprise.
The steel mill owner, on the other hand must keep that $100 at work in
the business. Otherwise the enterprise will suffer a real shrinkage in
earning power.
This principle applies to your own investments. Unless youve purchased
your stake at a substantial discount, it is not wise to reinvest in a
business that is earning sub par rates of return on capital employed.
If you own a farm equipment business with $1 million tied up in the
enterprise and it is only generating $30,000 after-tax income each
year, you would probably be in a better position if you liquidated the
company and reinvested in the cash in high grade municipal bonds. Youd
actually walk away with more money each year while spending your
entire day on the golf course.
The Bottom Line
Always know how much capital it takes for your businesses both wholly
owned and the marketable securities that make up your portfolio to
generate $1 in profit. To learn more, read Return on Equity: The
DuPont Model.
