ROCE and when to use it – return on capital employed

ROCE and when to use it – return on capital employed

ROCE and when to use it – return on capital employed

What is it?

ROCE measures a company’e profitability and it’s efficiency in using it’s capital, both shareholders’ funds and borrowings.

The higher the ROCE (return on capital employed), the better the performance. This is why investors like the ratio and investment analysts use it.

ROCE should not be confused with ROE – return on equity or ROA – return on assets. ROCE looks at the return on all funds employed by the business including long term borrowings.

How do you calculate it?

The calculation is simple – Earnings before interest and tax (EBIT) divided by capital employed. For ease of calculation, you can use the operating income from the Income Statement as the EBIT. Any extraordinary items should be included.

Capital employed is shareholders funds plus long term debt and can be easily calculated by taking total assets and deducting current liabilities. Long term loans are counted as part of the capital employed since it’s part of the company’s funds employed to produce profits.

For ROCE, usually the EBIT for the year is divided by the average capital employed (by taking the capital employed figures at the start and end of the year).

When to use it?

It is a powerful tool to use in not only comparing different companies’ performance but also analysing a company’s growth forecast. ROCE is the favoured ratio for capital intensive industries such as oil & gas, infrastructure engineering etc.

How to interpret it?

The concept is simple – for an investor, the higher the ROCE, the better the use of funds. It shows how good the management are in using the company’s capital to produce returns. ROCE is also extremely useful to look at past trends as well as evaluate future investments.

As an example, I have analysed a handful of ROCE ratios for some well known companies as below to compare and given my interpretation of what it means.

All 2013 figures.

Apple = 30% on capital employed of $163bn

Samsung = 23% on capital employed of Kw 163bn

Google = 15% on capital employed of $95bn

Amazon = 4% on capital employed of $17bn

GE = 3% on capital employed of $561bn

Glaxosmithkline = 25% on capital employed of £28bn

So how to interpret such a range?

Starting at the lowest, GE has seen much better days when it’s share price peaked 15 years ago and has gone through a period of restructuring. It’s also in mature and heavy industries that require a lot of capital. However, it’s been in business for a long period of time, is in most of the emerging markets and is a long term player, so expect the figures to improve over the next few years.

Next is Amazon, which hardly makes any profits on it’s $74bn of revenues. It has disrupted many industries and  gained market share by having the lowest price, which is it is still doing. It is now the leader in many sectors and expect prices to increase over the next few years as it takes advantage of it’s position. If you shop around online, you’ll know that in some areas, you can get better prices than Amazon now!

The 3 tech giants Apple, Samsung and Google all have excellent returns and the ROCE reflects that.

Apple gained much of it’s profits from the iconic iPhone and it will be interesting to see how it performs in the next decade. Samsung is interesting in that it is a vast conglomerate and whether it ever reaches the heights of exceeding a 30% ROCE is questionable though nothing is impossible.

Google is behind Apple and Samsung in ROCE terms but maybe not for long, given all the new tech areas it’s investing into.

The last company, Glaxosmithkline, I chose because it’s in a different sector and it shows just how profitable the pharma sector can be!

All the above companies have one thing in common – they all have large balance sheets and have invested heavily.

Key points to consider

  • ROCE is a powerful tool that measures how well a business uses it’s capital to get profits
  • It’s best used to analyse trends over a few years
  • Important for capital intensive industries
  • Use it for your business to compare with your competitors performance

Finally, as with any financial indicator, don’t look at it in isolation but use other measures as well to get a full picture of performance.

 

 

 

 

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