Spotting Profitability With Return on Capital Employed

Think of the return on capital employed (ROCE) as the Clark Kent of financial ratios. ROCE is a good way to measure a company's overall performance. One of several different profitability ratios used for this purpose, ROCE can show how companies use their capital efficiently by examining the net profit it earns in relation to the capital it uses.

Most investors don't take a second look at a company's ROCE, but savvy investors know that like Kent's alter ego, ROCE has a lot of muscle. ROCE can help investors see through growth forecasts, and it can often serve as a reliable measure of corporate performance. The ratio can be a superhero when it comes to calculating the efficiency and profitability of a company's capital investments.

Return on Capital Employed (ROCE) Defined

Put simply, ROCE reflects a company's ability to earn a return on all of the capital it employs. ROCE is calculated by determining what percentage of a company's utilized capital it made in pre-tax profits, before borrowing costs. The ratio looks like this:

The numerator, or the return, which is typically expressed as earnings before interest and taxes (EBIT), includes the profit before tax, exceptional items, interest, and dividends payable. These items are located on the income statement. The denominator, or the capital employed, is the sum of all ordinary and preferred-share capital reserves, all debt and finance lease obligations, as well as minority interests and provisions.

In the event that these figures—EBIT or the capital employed—are not available or cannot be found, ROCE can also be calculated by subtracting current liabilities from total assets. All of these items are also found on the balance sheet.

What Does ROCE Say?

For starters, ROCE is a useful measurement for comparing the relative profitability of companies. But ROCE is also an efficiency measure of sorts—it doesn't just gauge profitability as profit margin ratios do. ROCE measures profitability after factoring in the amount of capital used. This metric has become very popular in the oil and gas sector as a way of evaluating a company's profitability. It can also be used with other methods, such as return on equity (ROE). It should not be used for companies that have a large cash reserve that remains unused.

To understand the significance of factoring in employed capital, let's look at an example. Say Company A makes a profit of $100 on sales of $1,000. Company B makes $150 on $1,000 of sales. In terms of pure profitability, B, having a 15% profit margin, is far ahead of A, which has a 10% margin. Let's say A employs $500 of capital and B employs $1,000. Company A has a ROCE of 20% [100/500] while B has a ROCE of only 15% [150/1,000].

The ROCE measurements show us that Company A makes better use of its capital. In other words, it is able to squeeze more earnings out of every dollar of capital it employs.

A high ROCE value indicates that a larger chunk of profits can be invested back into the company for the benefit of shareholders. The reinvested capital is employed again at a higher rate of return, which helps produce higher earnings-per-share growth. A high ROCE is, therefore, a sign of a successful growth company.

ROCE and the Cost of Borrowing

A company's ROCE should always be compared to the current cost of borrowing. If an investor puts $10,000 into a bank for a year at a stable 1.7% interest, the $170 received in interest represents a return on the capital. To justify putting the $10,000 into a business instead, the investor must expect a return that is significantly higher than 1.7%.

To deliver a higher return, a public company must raise more money in a cost-effective way, which puts it in a good position to see its share price increase—ROCE measures a company's ability to do this. There are no firm benchmarks, but as a very general rule of thumb, ROCE should be at least double the interest rates. A return any lower than this suggests a company is making poor use of its capital resources.

Analyzing ROCE: Guidelines

Consistency is a key factor in performance. In other words, investors should resist investing on the basis of only one year's return on capital employed. Take a look at how ROCE behaves over several years and follow the trend closely.

A company that earns a higher return on every dollar invested in the business year after year is bound to have a higher market valuation than a company that burns up capital to generate profits. Be on the lookout for sudden changes—a decline in ROCE could signal the loss of competitive advantage.

Because ROCE measures profitability in relation to invested capital, ROCE is important for capital-intensive companies or firms that require large upfront investments to start producing goods. Examples of capital-intensive companies are those in telecommunications, power utilities, heavy industries, and even food service. ROCE has emerged as the undisputed measure of profitability for oil and gas companies which also operate in a capital-intensive industry. There is often a strong correlation between ROCE and an oil company's share price performance.

ROCE: Special Considerations

While ROCE is a good measure of profitability, it may not provide an accurate reflection of performance for companies that have large cash reserves. These reserves could be funds raised from a recent equity issue. Cash reserves are counted as part of the capital employed even though these reserves may not yet be employed. As such, this inclusion of the cash reserves can actually overstate capital and reduce ROCE.

Consider a firm that has turned a profit of $15 on $100 capital employed—or 15% ROCE. Of the $100 capital employed, let's say $40 was cash it recently raised and has yet to invest into operations. If we ignore this latent cash in hand, the capital is actually around $60. The company's ROCE, then, is a much more impressive 25%.

Furthermore, there are times when ROCE may understate the amount of capital employed. Conservatism dictates that intangible assets—such as trademarks, brands and research and development—are not counted as part of the capital employed. Intangibles are too hard to value with reliability, so they are left out. Nevertheless, they still represent the capital employed.

Disadvantages of ROCE Analysis

Even though it can be a good measure of profitability, there are several different reasons why investors may not want to use ROCE as a way to guide their investment decisions.

First of all, the figures that are used to calculate ROCE come from the balance sheet, which is a set of historic data. So it does not necessarily provide an accurate forward-looking picture. Secondly, this method often focuses on achievements that happen in the short-term, so it may not be a good measure of more longer-term successes a company may experience. Finally, ROCE cannot be adjusted to account for different risk factors from different investments a company has made.

The Bottom Line

Like all performance metrics, ROCE has its difficulties and limitations, but it is a powerful tool that deserves attention. Think of it as a tool for spotting companies that can squeeze a high a return out of the capital they put into their businesses. ROCE is especially important for capital-intensive companies. Top performers are the firms that deliver above-average returns over a period of several years and ROCE can help you to spot them.

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