Investors often look for the magic number or metric that will identify a great stock out of the universe of all stocks. This magic number doesn’t exist.
However, when you are considering stocks to buy, there are certain metrics and numbers that are more important than others. They can’t be used as the sole qualifier to determine great stocks, but you can use them to eliminate poor performers. One such metric is Return on Capital Employed (ROCE).
What is ROCE?
A financial ratio that measures a company's profitability and the efficiency with which its capital is employed. The formula for R.O.C.E. is
R.O.C.E. = Earnings Before Interest and Tax (EBIT) / Capital Employed
In the denominator we have net assets or capital employed instead of total assets (which is the case of Return on Assets). Capital Employed is the capital investment necessary for a business to function. It is commonly represented as total assets less current liabilities (or Fixed Assets plus Working Capital).
ROCE uses the reported (period end) capital numbers; if one instead uses the average of the opening and closing capital for the period, one obtains Return on Average Capital Employed (ROACE).
Meaning of ROCE
ROCE is a useful metric for comparing profitability across companies based on the amount of capital they use.
Consider two companies, A and B, which operate in the same industry sector. A has EBIT of INR 50 crores on sales of INR 1000 crores in a given year, while B has EBIT of INR 75 crores on sales of INR 1000 crores in the same year. On the face, it may appear that B should be the superior investment, since it has an EBIT margin of 7.5% compared with 5% for A.
But before making an investment decision, we need to look at the capital employed by both companies. Let’s assume that A has total capital of INR 250 crores and B has total capital of INR 500 crores. In this case, A’s ROCE of 20% is superior to B’s ROCE of 15%, which means that A does a better job of deploying its capital than B.
Significance of ROCE
· A higher ROCE indicates more efficient use of capital. ROCE should be higher than the company’s capital cost; otherwise it indicates that the company is not employing its capital effectively and is not generating shareholder value.
· ROCE is especially useful when comparing the performance of companies in capital-intensive sectors such as utilities and telecoms. This is because unlike return on equity (ROE), which only analyzes profitability related to a company’s equity, ROCE considers debt and other liabilities as well. This provides a better indication of financial performance for companies with significant debt.
· For a company, the ROCE trend over the years is also an important indicator of performance. In general, investors tend to favor companies with stable and rising ROCE numbers over companies where ROCE is volatile and bounces around from one year to the next.
Limitations of ROCE
The main drawback of ROCE is that it measures return against the book value of assets in the business. As these are depreciated the ROCE will increase even though cash flow has remained the same. Thus, older businesses with depreciated assets will tend to have higher ROCE than newer, possibly better businesses.
We will explain other Ratios like Free Cash Flow/Operating Cash Ratio which Fund Managers usually use while evaluating stocks in the next edition on Mirae Asset Knowledge Academy Tutorials.
Mutual fund investments are subject to market risks, read all scheme related documents carefully.