What is return on capital employed?
Return on capital employed, or ROCE, is a financial ratio that measures a company's profitability. More specifically, it can tell you how efficiently a company uses its capital to generate profits.
ROCE can be a valuable metric for comparing different potential share investments. The main benefit of ROCE over other return metrics, such as return on equity (ROE), is that it also considers a company's debt levels.
How to calculate ROCE
ROCE is a relatively straightforward financial metric to calculate yourself, using information readily available on a company's financial statements.
Just plug the relevant numbers into the formula below:
Return on capital employed = (Earnings before interest and tax expenses)/(Total assets – current liabilities)
Let's break down these components.
Earnings before interest and tax expenses (EBIT)
Sometimes referred to as 'operating profit', earnings before interest and tax expenses (EBIT) measure a company's core profitability. We calculate it by subtracting the cost of goods sold (COGS) and operating expenses from total revenues or by adding back interest and tax expenses to net income.
By excluding the company's interest and tax expenses, EBIT tries to isolate the earnings a company makes from its central business operations. Specifically, EBIT tells you whether a company is making enough revenue from its product sales to cover its operating expenses (such as employee costs and the money it pays to advertise and market its products).
EBIT is also a useful metric because it allows you to compare the profitability of companies with different capital structures and tax rules. For example, a junior growth stock may have higher debt levels than an established blue-chip stock, which may mean it has a higher interest expense and lower net income.
However, if the company has positive EBIT, it can begin to repay its debt using its operating income as it matures. This might indicate to growth investors that the stock is a good long-term investment.
Capital employed
We calculate capital employed by subtracting a company's current liabilities from its total assets. Current liabilities are usually short-term debts and other financial obligations that a company has to settle within the next year.
This leaves you with the company's shareholders' equity plus its long-term debt. This is the total capital that the company has raised to finance its business operations.
In the case of shareholders' equity, this is money the company has received from selling small ownership stakes – or shares – to investors. Long-term debt is money the company has raised by selling corporate bonds or borrowing directly from financial institutions.
If you want to determine how efficiently a company uses its capital, just calculate its ROCE.
How to use ROCE to evaluate a company
Let's illustrate with a simple example:
| Company A | Company B | |
| Sales | $5,000 | $2,000 |
| Cost of goods sold | $1,500 | $1,000 |
| Operating expenses | $3,000 | $700 |
| EBIT | $500 | $300 |
| Total assets | $10,000 | $2,500 |
| Short-term liabilities | $5,000 | $1,500 |
| Capital employed | $5,000 | $1,000 |
| ROCE | 10% | 30% |
First, we calculate each company's EBIT by subtracting the COGS and operating expenses from total sales. Each of these items will usually be listed in a company's income statements. Sometimes companies may even provide their EBIT as part of their financial disclosures, which saves you the effort of calculating it yourself.
Next, we calculate capital employed by subtracting short-term liabilities from total assets. Then, finally, we divide EBIT by capital employed to derive the ROCE for each company. In our example, it's 10% for Company A and 30% for Company B.
In dollar terms, Company A is clearly the larger company. It generates more than twice as much revenue as Company B and has significantly more total assets. However, Company B has a far superior ROCE. How can this be?
Firstly, Company A has relatively higher operating expenses. Company A's operating expenses are 60% of its sales, whereas Company B's are only 35%. This means Company A has an EBIT margin (EBIT/sales) of just 10%, while Company B's EBIT margin is a much healthier 15%.
Secondly, Company A's capital employed seems to be relatively larger, making up 50% of total assets (versus 40% at Company B). We'd need to have a closer look at the capital structures of each company, but this could indicate that Company A has more debt (and is more highly leveraged) than Company B.
This analysis tells us that – despite its much smaller size – Company B is using its capital more efficiently to generate its profits than Company A.
How to interpret ROCE
If we are investors looking to buy new stocks, based on the above example, we should put all our money into Company B. After all, it has the higher ROCE.
However, there are many other things we should take into consideration first. For example, the sector that a company operates in can significantly impact its ROCE. Some sectors – like the airline industry – are very capital intensive, meaning companies may need to borrow lots of money to pay for expensive machinery. This will increase their capital employed and could dilute their ROCE.
Other sectors, like consumer staples, may have much thinner margins. This is because companies in these sectors will often compete based solely on price. This might make their ROCEs seem low compared to growth stocks in the tech or healthcare sectors – but that doesn't mean they aren't suitable investments.
The important lesson is that ROCE is just one of the many financial metrics you should use when selecting a share to invest in. Although ROCE can tell you a lot about the relative profitability of different companies, there are many other factors to consider before investing in a particular stock.
ROCE vs. ROE: What's the difference?
As we touched on earlier, ROCE is a return measure that considers all of a company's capital, including its debt. Return on equity (ROE) only takes into account shareholders' equity. Many analysts prefer using ROCE as a return measure when comparing companies.
As we've already discussed, a business has two options when it wants to raise money to finance new projects. It can either sell more shares to equity investors via a capital raise or borrow money by issuing bonds or taking out new loans.
If a company is more inclined to borrow money than sell shares, this will be reflected in its capital structure. It will have higher levels of debt relative to equity. While this could mean it has a higher ROE than its competitors, it could make it a riskier investment. Interest repayments will be higher, and it could struggle when interest rates rise.
This all means that, in many cases, ROCE gives a clearer picture of a company's overall profitability because it takes into account its entire capital base.
What is considered a good ROCE?
ROCE can vary significantly between different industries and sectors. Some sectors are more highly leveraged, while others have tighter margins. And plenty of other differences between industry groups can impact a company's ROCE.
Obviously, the higher the ROCE the better, as this means that a company is more efficient and profitable. But what constitutes a 'good' ROCE can vary quite a lot. The best way to use ROCE is to compare multiple companies in the same sector to determine which is more profitable. This can help you decide which share might be the best value.
What are the limitations of ROCE?
We have already covered some limitations, but there are others to be aware of, too.
- ROCEs can differ significantly for companies operating in different sectors of the economy: While a high ROCE is always preferable, it is only significant when compared against competitors with similar business models or the industry-wide average. Looking at one company's ROCE independently doesn't tell you if it is more or less efficient than its peers.
- ROCEs can be volatile: A company's returns can vary significantly from one reporting period to the next, especially if the company is a junior growth stock. Therefore, it often helps to look at how a company's ROCE has been trending over time rather than just taking one period in isolation.
- Cashed-up companies can have lower ROCEs: If a company has large amounts of cash sitting on its balance sheet as an asset, this can inflate its capital employed (because, remember, capital employed equals total assets minus current liabilities) and ultimately decrease its ROCE.
However, a company with larger cash reserves might make a better investment, as it is potentially lower risk and can pursue growth opportunities without having to raise additional capital from the debt or equity markets.
The lesson is, don't take a company's ROCE at face value – look under the hood at its financial statements to see what's driving a low or high ROCE.
Always remember, ROCE is just one metric in your financial toolkit. Combining it with other forms of company analysis is the best way to make effective investment decisions.
