Return on Capital and Return on Stock

(5 of 7)

Return on Capital and Return on Stock

The market often takes a long time to reward shareholders with a return on stock that corresponds to a company's return on capital. To better understand this statement, it is crucial to separate return on capital from return on stock. Return on capital is a measure of a company's profitability, but return on stock represents a combination of dividends and increases in the stock price (better known as capital gains). The two simple formulas below outline the return calculations in more detail:

Return on Capital: Profit / (Invested Capital)

Return on Stock: Shareholder Total Return = Capital Gains + Dividends

How the two measures connect and disconnect

The market frequently forgets the important relationship between return on capital and return on stock. A company can earn a high return on capital but shareholders could still suffer if the market price of the stock decreases over the same period. Similarly, a terrible company with a low return on capital may see its stock price increase if the firm performed less terribly than the market had expected. Or maybe the company is currently losing lots of money, but investors have bid up its stock in anticipation of future profits.

In other words, in the short term, there can be a disconnect between how a company performs and how its stock performs. This is because a stock's market price is a function of the market's perception of the value of the future profits a company can create. Sometimes this perception is spot on; sometimes it is way off the mark. But over a longer period of time, the market tends to get it right, and the performance of a company's stock will mirror the performance of the underlying business.