Flash Economics Economic Research author Patrick Artus would have us look at return on capital differently – instead of financial (equity) capital, physical capital affords us a whole new perspective on evaluating investments across the developed countries such as the U.S., U.K., France, Italy, Germany, Spain and Japan.

Financial versus Physical Capital

The analyst suggests we look beyond the funneled view of return on equity (which serves only the shareholders) to return on physical capital, which is the aggregate return made by a company on all its different forms of financing, whether loans or capital.

The problem with equity oriented financial capitalism is that the return expectations on the investment run too high. This excessive pre-occupation with return on equity (RoE) can drive investors towards short-term and speculative assets and management towards cost cutting that could be unfair to employees.

The graph below shows the RoE across the developed countries mentioned above:

1-ROE Capital

Return On Physical Capital

If we replace RoE with physical capital, we can look at aggregate profitability (after tax but before dividends and interest) as a percentage of the country’s GDP, this being the return available to both lenders and shareholders. The graph below shows how this method looks for the developed countries:

2-PROFIT-FOR-GDP

Here, we also need to look at the capital intensity of the country – the ratio between the total money value of capital equipment to its nominal GDP. How does an increase or decrease in capital intensity affect the profitability as a percentage of GDP?

2A-capita;-vs-gdp

Another way is to calculate the aggregate profits after tax, but before interest and dividends, as a percentage of total capital employed in companies in value terms. Country-wise returns by this method are shown below:

3-PBT-BEF-INTT-DIV

Observations

For each country the three methods throw up somewhat different results. But we can say that:

  • The U.S., U.K. and Germany show high return on physical capital while Spain is turning up recently. However, returns are low in France, Italy and Japan.
  • Interestingly, the countries with low returns show relatively higher capital capital intensity. Why?

Conclusion

The analyst suggests that the phenomenon is explained by “the level of product sophistication and the nature of the capital: the United States and the United Kingdom invest markedly more in new technologies than the euro zone and Japan.”

The continued use of traditional methods to manufacture “standard” industrial products necessitates the use of excessive capital that in turn reduces returns, and therefore discourages investors.

The analyst therefore argues that RoE is really not to blame – the real, underlying reason may be a low rate of return on physical capital.