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How Much is a Fair Profit? – Part IV of V Return on Capital

Return on Capital

For all investors in business, capital is the fronted equity an investor risks in exchange for a return.  This return can range from zero to infinity depending on the success of the business.  A fair profit is really a function of four different factors.  They are as follows: 

  • Part I owner’s compensation plays the most pivotal role in the profit formula. If the owner’s payroll exceeds the normal payroll for the same function in the business operation, the owner is effectively taking profit from the company.  If the owner’s payroll is less than reasonable, then the owner is allowing the profit to increase via the reduction in his own compensation.  This is discussed in detail in my article explaining the aspects of the owner’s compensation package – How Much is a Fair Profit – Part I of V Owner Compensation.
  • Part II the economic cycle affects the profit too. In many businesses, the economic cycle is not an annual event.  Many businesses have economic cycles that mimic ocean waves.  There is a crest of high activity and then there is the low point.  The key is to understand this economic cycle for your industry and adjust the profitability up and down related to the time point in the cycle.  I encourage those of you that are novices or intermediate level business entrepreneurs to understand the impact of the economic cycle on your business by reading my article – How Much is a Fair Profit – Part II of V The Economic Cycle.
  • Part III risk is the third factor in calculating a fair profit for your business. Risk is divided into two distinct groups, those that can be mitigated via insurance and uninsurable risks.  Uninsurable risks pose the greatest threat to the overall profitability.  These include external and internal forms of uninsurable risk.  Internal forms can be controlled based on good policies and procedures implemented by management.  External risks can only be identified and influenced by the business owner.  I explain all of this in more detail in my article – How Much is a Fair Profit – Part III of V Risk. 

This article covers the fourth factor in determining profit which is return on capital.  The final article (unwritten at the time of release of this article) goes through the process of creating the formula for your business and provides several examples of how to use the formula. 

Return on capital is really a derivative of several functions of money and business itself.  In a very conservative nature any investor is looking for a pure interest return on their investment.  That is ‘NO’ risk and some interest on their investment.  You see this in the purchase of government backed paper.  As the investor begins to invest in lower quality positions the return on the capital investment needs to increase.  This is due to the nature of the investment.  Notice that I have covered the other significant risks associated with a return on the investment in regards to the economic cycle and the risks of business.  But there are more risks that affect the return on the capital.  These include industry related performance, economy of scale issues and finally personal beliefs in return on the investment.  The following sections cover return on capital as it relates to a purely conservative investment to the other factors identified. 

Pure No-Risk Conservative Return 

The absolute no risk scenario for money is a safe deposit box.  Seriously, if you absolutely want no risk on your investment, put the money in a safe deposit box.  Even then there is some risk because the bank could catch fire or drop in a sinkhole.  But the reality is that your money will be there next year.  Of course for this no risk scenario, you get a ZERO return, a big fat Goose Egg.  So, is there someplace where our money is safe and we can get some interest on it?  Sure enough our federal government to the rescue (interesting way to put huh?).  The following are the order of different government securities based on their duration of maturity. 

Treasury Bills (T-Bills)

Now you can buy treasury bills (T-Bills) which have a maturity of less than one year.  The current interest rate is about .21% for a 52 week position.  You can buy shorter positions down to four weeks.  T-Bills are sold in increments of $1,000 for a certain price.  Basically you are purchasing a form of a dollar bill that has a $1,000 face value.  You pay a certain discounted price for this T-Bill and must hold it until it matures.  The current discounted price is $997.88 for a $1,000 face value.  These can be purchased directly from the US Treasury or through a bank. 

Treasury Notes (T-Notes)

Unlike T-Bills, T-Notes have a minimum maturity of 2 years and increase in various increments up to 10 years.  The current annual interest rate for a 2-year T-Note is .625% and a 10-year is up to around 2.25%.  Why the difference?  Simple economics, which note has more exposure to inflation changes?  Did you forecast the recession of 2008 before or after the recession hit?  So the longer the exposure, the more interest the buyer desires.  Now, remember, this is a federal government piece of paper.  Not that there isn’t risk in an entity that owes $17 TRILLION to various entities to fund its operations.  Seriously, our government can default but by the shear nature that it has the power to tax the people and pay the debt is the basic security the paper carries. 

Treasury Bonds

This form of investment is a straight forward 30 year document.  You pay the face value and receive interest from the United States every 6 months.  At maturity, you receive your face value back.  Current interest rates are running around 3%.  Again notice that the longer you are required to hold the paper, the higher the interest rate paid. 

There are other types of government securities.  Many states issue bonds for particular projects and these usually pay a little more than federal types of treasury instruments.  But there is a slightly higher risk involved.  Many state bonds are designed for particular projects like highways or sewer systems and so on.  So the bond revenue is based on the project and often states are not allowed to tax the citizens to cover any shortfalls.  Therefore, a slightly higher return on your investment is built into the price of the bond.  Sometimes the bonds are tax free at the state level of taxation, thus reducing the interest rate paid on the bond.  So there are a lot of factors involved in how much interest state bonds pay.  This is also true for local bonds, usually school or facility construction projects. 

You can purchase higher risk paper such as Bank CD’s (Certificates of Deposit) and receive a relatively low rate of return.  I often wondered about this because banks don’t have the credit worthiness of government, yet sell these forms of paper for often lower rates of return.  Goes to show you how the public has more faith in their local bank than they do the government (WARNING CONGRESS, WARNING!).  To make matters worse, the banks charge greater penalties than the federal government for early withdrawal.  If you are going to buy a CD, shop around, you’ll be surprised. 

As an investor, this section helps you to understand how an investor needs to look at his return on his capital given the nature of the investment.  So let’s move onto more risky types of investments at the next level. 

Economy of Scale Return 

If you’ll notice, in the government based securities that pay relatively low interest rates, the volume of sources of revenue are pretty much unlimited.  Basically, if the government gets into trouble it can tax all 300 million citizens.  That is one heck of a customer base.  In business, I don’t think that the large corporations can even come close to that size of customer base.  Let’s think of Walmart.  Remember, Walmart is the number one company in the world.  I’m pretty sure just about every person in the US has stepped foot inside of a Walmart.  This doesn’t mean that they have all 300 million as customers, but it does mean that they have a vast customer base. 

So the risk in lending money to Walmart does exist.  However, it is relatively safe.  Not as safe as the federal government security, but safe.  Now remember, we are talking about the equity position in a company, not the lending position.  Remember in corporation formats, the lenders are paid before the stock holders in case of default.  The return on your investment relates directly to the possibility of default.  It is unlikely that Walmart will default in 2015.  Therefore, the return on the investment is less risky than putting up money for your son’s grand business scheme.  Thus a lower rate of return is expected for the Walmart investment. 

This is how the economy of scale comes into play.  The average price to earnings (P/E) ratio for Walmart for the last three years has been as low as 11.25 and as high as 17.9.  So a $1,000 stock purchase three years ago was earning around $89 from Walmart.  Currently in December of 2014, it is earning only $56.   This doesn’t mean you’ll get those dollars in your pocket, it just means Walmart has earned that money per $1,000 of stock price.  Therefore the return on the investment ranges between 5% and 9% and this is for the largest corporation (sales volume) in the world.  Notice how the risk element has increased slightly and the return on the investment has gone up too. 

As we head towards more localized industries, we should see an increasing risk and therefore an increasing return on the investment.  Let’s find out. 

Industry Related 

There are a lot of localized industry investments.  There are shipyards, train systems, port authorities, and energy companies.  So let’s use a power company and I’ve selected Con Edison of New York.  On October 1, 1882, the Edison Electric company had 59 customers.  Today, Con Edison serves 3 million customers.  So is there risk?  Yes, but nowhere near the risk back in 1882.  During the last 3 years, the PE ratio reached a high of 18.21 and a low of 13.  Therefore, its return on investment range is between 5.5% and 7.6%.  

Wait a minute Dave; you said that as the customer base decreases the return on the investment really needs to increase.  I sure did.  But this illustration shows that the maximum return on the investment is actually lower than Walmart’s.  And yes you are correct.  Here we have an example of a smaller company than Walmart and yet the return on the investment is obviously lower.  This is because of the regulation that exists in the energy industry.  By eliminating competition, the state government of New York allows Con Edison to make a profit; almost like a guaranteed profit.  In exchange for this allowance, Con Edison isn’t allowed to just raise the rates whenever they want.  Walmart can increase their prices whenever they want.  But Walmart has no guarantee of making a profit.  

To prove this profit issue, did you know that in 2004, Walmart’s earnings per share was $2.07, but in 2013, the earnings per share exceeded $5.  That’s a significant range of earnings over a 10 year period. 

Con Edison’s earnings per share were as low as $2.50 per share and reached a high of $5.00 per share during the same period of time.  So Con Edison’s earnings per share were slightly more stable but with a lower volume of customers.  The key is the government regulations involved.  In addition, Con Edison consistently paid out around 60 cents per share per year.  The dividend yield is around 3.7% per year. 

Whereas with Walmart; the dividend was 36 cents in 2004 and $1.88 in 2014.  Since the dividend is much higher as Walmart progresses through the period, the dividend yield is higher and therefore return on the investment is better with Walmart.  But my goal is to demonstrate that as you begin to localize the business, the yield should increase.  I used this example due to the nature of government involvement in regulating industry.  For Con Edison the upside potential in the stock price is limited whereas with Walmart, it is much greater.  

So let’s take a look at a low regulated localized industry and see what happens with the return on the investment.   In this case, I’m going to use Union Pacific, a railroad company based out of Omaha Nebraska with 8,300 locomotives.  The company has 46,000 employees. 

Union Pacific’s P/E ratio in 2004 was 10.8 and is currently running the high of 22.23.  This means the company earns between $93 per share down to $45 per share during this period of time.  So its range is between 4.5% up to 9.3% in earnings.  The company paid out dividends of $1.20 back in 2004 and paid out $2.36 in calendar year 2014.  The current dividend yield is 1.67%.  

Here is the real value change.  In 2004 a single share cost around $18.  Today (Dec 2014), it is over $120 per share.  ONE HECK OF AN INVESTMENT!  That’s a whopping 19.12 percent per year increase over 10 years.  In addition, there is a dividend payment of 1.67% per year.  

Walmart’s stock price in 2004 was $54 and today it is $87.   That’s a 5% per year return on your investment. 

Do you now see the difference?  The risk factor is higher with Union Pacific and therefore the return on the investment is significantly higher to cover that risk exposure.  By the way, based on my readings for Union Pacific, that is one well managed company.  The following chart sums up this relationship: 

 Company       Risk Exposure          Return on Investment (Avg 10 Yrs)
Walmart             Low                                    Approximately 7.3%
Union Pacific     Low (But > Walmart)        Approximately 20% 

Now I’m not a broker or a private investor, so please don’t run out and buy either party’s stock.  You need to consult a broker.  My goal here is to illustrate the increasing return on capital as the risk increases with default.  The next section should really drive home the point as it relates to investing in your own company. 

Personal Beliefs 

Immediately you should realize that if Union Pacific with a low risk exposure is returning that much per year, then for any investment in a small privately held format should earn more.  Now the Union Pacific example is actually pretty extreme.  Usually you’ll see rates of return heading towards 10% per year for the publically traded companies that are not NY Stock Exchange based.  I’m referring to over the counter types, penny stocks and so on.  

So for you as an investor, you should desire returns of 20% or more for your investment in a small business.  This return can be determined via the change in equity value and of course including any dividends or distributions you receive from the investment.  

However, and I say this in a cautionary way, much of the risk element is addressed in my article How Much is a Fair Profit – Part III of V RiskSo in this case, what you really are seeking is a return on the investment with a relatively low risk exposure and in my mind, this should be greater than Walmart but lower than the rates currently generated with publically traded companies.  Therefore, a reasonable expectation of 8 to 10 percent is warranted.  Remember this article is about calculating the return on capital related to a low risk investment because we determined the profit needed to offset risk in my prior article. 

The next article ties all the parts together so that as an investor in small business you can reasonable calculate a fair profit required to offset all the factors involved – compensation, economic cycle, risk, and of course a return on capital.  Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org.  I would love to hear from you. If interested in my services as an accountant/consultant; click on My Services in the footer of this article.

 

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About David J Hoare (387 Articles)
I spent 12 Years as a Certified Public Accountant, Over 20 Years of Practice in Accounting and Consulting, Controller in Management of Closely Held Operations, Masters of Science in Accounting, Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns