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Business-Like Investing

Focus on Return on Capital Employed

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The single most important indicator of the inherent excellence of a business is the return on capital employed. You’ve 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 you’ve 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. You’d 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.

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