Before deciding whether or not to invest in a particular company, you’ll likely want to know its profitability – and return on capital employed, also known as ROCE, is one method to help you gauge this.
Here, Telegraph Money explains how ROCE is calculated and what it is used for. This guide will cover:
Return on capital employed, or ROCE, is a key financial ratio that investors can use to assess the profitability of a business.
How efficient is a company at deploying capital? Simply, this can be answered by finding out how much profit before interest and tax the business returns as a percentage of every 1pc of capital invested. Or, if a company has a ROCE of 10pc that means for every £1m of capital invested in the business, it would yield a profit of £100,000.
The formula for ROCE is earnings before interest and tax (EBIT) divided by capital employed. The latter is calculated as total assets minus current liabilities, or as shareholders’ equity plus long-term debt.
For an investor who likes to sift through company reports, EBIT information can be found on an income statement, while the capital employed can be calculated from information on the balance sheet.
A straightforward metric, ROCE is used to determine how well a company uses its capital to generate returns. The uniqueness of the measure is how it combines other formulas used to determine that same answer.
Some metrics are great at expressing simple profitability. There are dedicated functions that either look at net profit margins and gross profit margins, or are solely concerned with what is in the balance sheet. ROCE combines the two.
Using the metric to find the relative profitability of companies, especially when compared with that of similar businesses, can be extremely useful. Or, indeed, it can also inform decisions about investing in something entirely different. While ROCE can seem similar to return on assets (ROA), it has some key differences.
Looking at some of the larger names in the UK market, the ROCE numbers differ by industry and business, depending on the markets they operate in.
Capital-intensive industries like energy and pharmaceuticals may have a lower ROCE due to the high levels of capital expenditure needed to operate. Tech companies, on the other hand, tend to have a higher ROCE due to lower capital intensity.
External factors can have an adverse effect on the efficiency of capital employed, and energy companies operate against changing global commodity prices, while banks are influenced by interest rate changes, the credit market and broader economic conditions.
According to data from the stock valuation platform Alpha Spread, Unilever has an ROCE of 20.7pc – its historical five-year average sits around 19pc. Given its operations around the world and diverse range of products, it sits in the higher range.
The same data set reveals BP, sensitive to the fluctuations of the energy market, has an ROCE of 11.3pc compared to its five-year average of 13pc.
While certain factors like market conditions and investor sentiment act as external forces, a company can act to either increase its profitability (EBIT) or reduce the capital employed.
Now this sounds simple, but there are several ways to do this. A tool like gearing, or debt, when used well can increase return on equity and capital employed.
Divesting in underperforming assets, utilising or upgrading the assets already at its disposal, or leasing assets instead of owning them in high capital intensive industries, can also improve efficiency by reducing the amount of capital employed.
Take the same example of Unilever – product innovation and expanding into new markets or countries can vastly improve revenue growth.
Metrics can give a snapshot, but often not the whole picture. This is especially true of ROCE, and while it is one of the few that combine profitability and balance sheets, it fails to offer a sense of scale.
A percentage score of 10-20pc for a well-known company like BP or Unilever can be rationalised, but if you head further down the market cap spectrum, the ROCE metric in isolation falls short.
The figure is inherently backward-looking, and is almost certainly out of date by the time an investor has looked at the numbers.
It is also based on the most recent earnings and does not take into consideration the long-term growth prospects.
Take Nvidia, which according to Morningstar data, has an ROCE of 118.72pc – the company has on average over the last five years reported a ROCE of around 20-30pc. Nvidia’s business model relies heavily on its intellectual property and high-margin hardware sales, which lends itself to significant returns on invested capital.
Plus, the company has consistently reinvested its profits into research and development (R&D), and acquisitions, to prioritise future growth. So, a depressed ROCE while a business invests heavily in infrastructure and R&D ignores the potential for longer-term financial gains.
There is also no sense of risk in an ROCE percentage. The ROCE of BP is a reflection of the capital-intensive nature of its industry, but there is no recognition of the longevity of these returns and how long a company in the oil and gas space can sustain its long-term profitability.
A “good” ROCE in isolation is difficult to gauge as there are a few factors to consider aside from the number itself. That said, an ROCE of 15-20pc is considered good and anything over 20pc is considered excellent.
But without taking into account the industry the business operates in, its future growth prospects, cost of capital and sustainability of returns, it is difficult to rely on a “good” figure on its own.
ROCE measures the overall profitability of capital employed including equity and debt. Whereas return on equity (ROE) focuses on the returns to shareholders after interest payments.
A higher ROCE than ROE may suggest higher uses of leverage, or debt, which will boost capital efficiency but not benefit shareholders in the same way.
This is not necessarily a bad thing and gearing – when used efficiently – can be a powerful tool to have in a company’s arsenal. But if a business is overleveraged, this can be a dangerous place to be for investors.
The two are related, but not the same. Profitability ratios mentioned earlier including net and gross profit margin are related to how well a business generates profit relative to revenue.
ROCE takes into account the company’s profitability but alongside how efficiently it uses all of its capital, including equity and debt, to yield earnings.
No ratio is perfect and in isolation it paints a fairly limited picture. That said, compared to other financial metrics, ROCE provides a comprehensive look at how efficiently capital is employed in generating profit.
For that reason, it’s on the more useful end of measuring profitability and, when used in comparison to companies in the same sector, it can be a good indicator to an investor before employing their capital in its shares.
However, an attractive figure on return on capital says nothing for the stock price or how it is trading relative to its historic average, nor the long-term prospects for that business and the industry it operates in.
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