Updated 5/1/2024

Cash is king, and finding companies that are superior reinvestors of that cash is one of the trifectas of investing success. One of the easiest ways to find these companies is a formula called Cash Return on Invested Capital.

The CROIC formula is a bit of an inside-baseball formula. Wall Street doesn’t talk about free cash flow, as the focus is much more on earnings than free cash flow and its uses.

Free cash flow is the source of reinvestment, not only in the business but also provides sources of cashback to us in the form of dividends or share repurchases.

From Warren Buffett:

“To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”

In today’s post, we will discuss:

• What is Cash Return on Invested Capital
• The Formula for Cash Return on Invested Capital
• How to Calculate Cash Return on Invested Capital with Examples

Ok, let’s dive in and find out how this formula works.

What is Cash Return on Invested Capital

According to Investopedia:

“Cash return on capital invested (CROCI) is a valuation formula that compares a company’s cash return to its equity. Developed by the Deutsche Bank’s global valuation group, CROCI gives analysts a cash flow-based metric for evaluating a company’s earnings.

CROCI is also referred to as “cash return on cash invested.”

If you are interested in reading the paper from Deutsche Bank, click below:

CROCI: A Real Value Investment Process

Cash return on invested capital measures the cash a company generates compared to the equity required to create the cash.

It measures a company’s operating profit compared to its total equity, which includes both common and preferred shares of equity.

The CROIC formula shows you how much free cash flow per dollar the company creates from invested capital, including equity and debt, to create that cash flow.

What I like about this metric is that it helps highlight companies that are effective with their cash and illustrates the strength of the business.

As with most metrics, the higher the number, the better; we are looking for companies that generate high returns on the cash they produce.

If you feel adventurous, you can substitute free cash flow for Buffett’s owner earnings, which is essentially the same idea from Buffett’s point of view.

You will find some formulas online that include EBITDA as the numerator. Still, I stay away from the metric as it includes items that should be subtracted from cash flow, such as depreciation, which, in my mind, is certainly a cash expense. But that is another can of worms we can tackle at another time.

Ok, let’s jump in and look at the formula for cash return on invested capital.

The Formula for Cash Return on Invested Capital

The formula for a cash return on invested capital is similar to a return on invested capital except that it focuses on the company’s free cash flow and more on the equity and debt-financed capital.

We talk a lot about debt and the many bad outcomes that too much debt can cause, but debt also drives a lot of returns as it allows companies to use those funds to reinvest back in the business.

The formula for CROIC is:

CROIC = FCF / Invested Capital

Let’s break those parts down to make it a little more palatable.

Defining the numerator of the formula, we see the free cash flow and the breaks out as:

NOPAT = Net operating profit after Tax

That mouthful means operating income multiplied by the company’s current tax rate.

Free Cash Flow = Operating Income x (1-Tax Rate)

Ok, so that is pretty easy.

Now, the denominator is up next.

Invested Capital includes items such as shareholders’ equity, short-term debt, and long-term debt, or:

Invested Capital = Shareholders’ Equity + Short-term Debt + Long-term Debt

As we work through these calculations, I will pull from the annual reports so you can see where the numbers come from that we will use in the formulas. Remember that each company might list these items differently on each financial report. Until the day arrives that the accounting standards require companies to list all short-term debt as such, we might have to try to interpret a little from time to time.

The hard sometimes makes it fun; if it were easy, everyone would want to invest.

Let’s examine a few companies and determine their cash return on invested capital ratios.

A note about doing these calculations: again, this is a bit of an inside baseball formula, so it won’t be listed on a lot of financial websites, so it is a great one to be able to calculate it yourself.

The bonus of the extra work is that it is not difficult to calculate once you know where to gather the data.

How Do you Calculate Cash Return on Invested Capital?

Example: Disney

The first company I would like to analyze is Disney (DIS). Disney is one of my favorite companies to analyze because its financial reports are fairly straightforward and transparent about its numbers, which makes our job a little easier.

Okay, so breaking the formula into parts, we will look at two financial reports, the income statement and the balance sheet, to find our numbers.

After pulling up sec.gov and finding Disney’s latest 10-k, we will find both reports and highlight the data we need to calculate our formula.

Before moving on, we need two numbers: income taxes and income from continuing operations or operating income. We use the following formula to calculate Disney’s current tax rate.

Tax Rate = Income Taxes / Operating Income before Taxes

To calculate operating income, we also need to do a little calculation.

Operating income = Revenues – Total Costs and Expenses

Okay, I will now grab a screenshot of Disney’s income statement and highlight the line items we need for our numbers.

Pulling the numbers from the above income statement, we get the following:

• Revenues – $69,570
• Total Costs and Expenses – $(57,719)
• Income Taxes – $3,031
• Income Before Income Taxes – $13,944

To calculate Disney’s free cash flow, we can first calculate the tax rate it paid for the year ending in 2019.

Tax Rate = Income taxes / Operating Income

Tax Rate = 3031 / 13944

Tax Rate = 21.73%

To find the operating income, we pull the numbers from above.

Operating income = Revenue – Total costs and expenses

Operating income = 69570 – 57719

Operating income = $11,851

Then, we plug the tax rate into the free cash flow formula.

Free Cash Flow = Operating income x (1- Tax Rate)

Free Cash Flow = 11851 x ( 1 – .2173 )

Free Cash Flow = 11851 x ( .7827)

Free Cash Flow = 9275.78

Now, we need to go to the balance sheet to gather our other numbers for the denominator of our formula. I will highlight the items needed for the next calculations.

Ok, so pulling the numbers from the above balance sheet:

• Short-term Debt (Current portion of borrowings) – $8,857
• Long-term Debt (Borrowings) – $38,129
• Total Shareholders’ Equity – $88,877

As you can see from Disney’s balance sheet, they don’t outright state that those line items are short-term or long-term debt, but we can infer from common sense what those terms mean; unfortunately, as I stated before, there is no common thread for the naming of different line items so sometimes you will have to use logic to figure it out.

I have faith you can do it; I believe in you!

To calculate the invested capital portion of the formula, we:

Invested Capital = Short-term debt + Long-term debt + Total Shareholders’ Equity

Invested Capital = 8857 + 38129 + 88877

Invested Capital = 135863

Now, let’s combine the two parts of the calculated formula.

CROIC = Free Cash Flow / Invested Capital

CROIC = 9278.78 / 135863

CROIC = 6.82%

Now, wasn’t that easy? The result is a little disappointing. I would ideally like to find a company with a CROIC of above 10%.

Example: Visa

Ok, let’s try another, shall we? How about Visa (V) this time?

I will pull up the financials and highlight the line items we need to calculate our formula for CROIC.

We will pull our numbers from the above financial statements to find the CROIC for Visa.

I wanted to point out that Visa lists the line items more clearly than Disney does. You can see the operating income without calculating the numbers; also, the long-term and short-term debts are listed clearly. These illustrate the point I was trying to make earlier: there is no uniform method for listing each line item, which can make it a touch more confusing.

The numbers for our formula are:

• Operating income – $12,594
• Income Taxes – $2,505
• Income before Income Taxes – $12,806
• Current maturities of long-term debt (short-term debt) – 0
• Long-term debt – $16,630
• Total Shareholder Equity – $34,006

Now, we can plug all of our numbers into the formula.

CROIC = (( Operating Income x (( 1 – ( Income Taxes / Income before Taxes )) / ( Short-term debt + Long-term debt + Shareholders’ Equity )

CROIC = (( 12594 x (( 1 – ( 2505/12806)) / ( 0 + 16630 + 34006 )

CROIC = (( 12594 x ( 1 – .1956 ) / 50636

CROIC = 10130.61 / 50636

CROIC = 20.00%

Visa does a fantastic job of reinvesting its cash, generating $0.20 of free cash flow from every $1 of operating income, which is outstanding. Compare that to the level that Disney is currently performing, and you can see that Visa is more efficient using free cash.

Example: Netflix

Let’s take a look at one more just for giggles. How about we look at Netflix (NFLX)?

For this example, I will pull the data from their income statement and balance sheet for us to calculate.

The data we need for our formula:

• Operating Income – $2,602
• Income Before Income Taxes – $2,062
• Income Taxes – $195
• Short-term debt – 0
• Long-term debt – $14,759
• Shareholders’ Equity – $7,582

Now that we have our numbers, we can assemble our formula to calculate Netflix’s cash return on invested capital.

CROIC = (( 2602 x ( 1 – (( 195 / 2062)) / ( 0 + 14759 + 7582)

CROIC = (( 2602 x ( 1 – .0945 ) / 22341

CROIC = 2356.11 / 22341

CROIC = 10.54%

Netflix also does a good job of creating free cash from their operating income, not as well as Visa, but much better than Disney.

These are useful exercises for determining the profitability and efficiency of different companies, plus they are great tools for screening for companies that are great capital allocators.

For example, I will calculate a few more to give us a flavor of how this works in several industries.

• Apple – 27.06%
• Amazon – 9.64%
• Tesla – 0.35%
• Exxon – 3.82%
• Verizon – 13.63%
• Microsoft – 21.35%
• Mastercard – 55.2%

As we can see from the smattering of results from a few industries, tech companies rule this ratio. It is not a great indicator for financials as more liabilities are tied up in deposits than debt. Banks, like many in the tech world, use deposits to fund their growth rather than debt.

Final Thoughts

Every investor aims to find companies that are great capital allocators. Using a tool like the cash return on invested capital is a great formula for finding those companies.

Warren Buffett speaks many times in his Letters to Shareholders about the importance of capital allocation. To him, it is probably the most important role a CEO can play. He believes returning capital to shareholders is job number one, and finding leaders who excel in this area is rare. Buffett laments this fact and states that most CEOs struggle with this role because they are either operators or salesmen, which is how they rose to the CEO role. However, those strengths often lead to struggling to become world-class capital allocators, which is what Buffett seeks when determining the viability of buying any particular company. He often says great management is just as important as a great price.

Buffett often refers to buying a company that any idiot can run because, eventually, one will!

The formula we discussed today is fairly simple; the most difficult part is navigating the line items from the financial statements to find the data we need. As with all formulas, this one should be used with others to help you form your opinion of the company. Never use this one formula or any others as your sole decision-maker when making a buying or selling decision. Rather, use tools like the cash return on invested capital formula as another part of your checklist.

That will wrap up our discussion today on cash return on invested capital.

As always, thank you for reading this post. I hope you found something valuable in your investing journey.

If I can further assist, please don’t hesitate to reach out.

Until next time.

Take care and be safe out there,

Dave