What is Return On Capital Employed ( ROCE ) and what you should derive from it for value picking?

A ratio that indicates the efficiency and profitability of a company's capital investments.

                                 Earnings

  ROCE =    -------------------------------------------      X 100    

                          Capital Employed

•         The numerator is Earnings before Interest & Tax. It is net revenue after all the operating expenses are deducted

•         The denominator (capital employed) denotes sources of funds such as equity and short-term debt financing which is used for the day-to-day running of the company. Capital Employed is represented as total assets minus current liabilities. In other words, it is the value of the assets that contribute to a company’s ability to generate revenue

ROCE value from Finance sheet tells us …

•          It is a useful measurement for comparing the relative profitability of companies

•          ROCE does not consider profit margins (percentage of profit) alone but also considers the amount of capital utilized for those profits to happen

•          It is possible that a company’s profit margin is higher than that of another company, but its ability to get better return on its capital may be lower

•          ROCE should always be higher than the cost of borrowing

•          An increase in the company’s borrowings will put an additional debt burden on the company and will reduce shareholders’ earnings

•          So, as a thumb rule, a  ROCE of 20% or more is considered very good

•          If a company has a low ROCE, it means that it is using its resources inefficiently, even if its profit margin is high.

Drawbacks 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. In addition, while cash flow is affected by inflation, the book value of assets is not. Consequently revenues increase with inflation while capital employed generally does not (as the book value of assets is not affected by inflation).