What is the role of return on capital employed (ROCE) in stock investing?
Return= Profit Generated from Amount Invested/Amount Invested * 100
Return= 50,000/5,00,000 * 100 = 10%
Similarly, return on capital employed (ROCE) is the operating income (or operating profit) generated by the company with respect to the capital it deployed.
So what is the capital? To run any business you need money right? In case of stock listed companies this money is the initial money that was borrowed or generated by the company by issuing shares to the general public (equity) + any long term loan (short term loans not included) that was taken by the company to run its business operations. This loan taken could be from banks or other financial institutions or third parties.
All this borrowed money (equity + loan+ money generated by issuing bonds etc) becomes the capital of the company irrespective of how the company deploys this money into their business. The company could even buy a machine(or equipment) or a building by spending a small portion of this money. Thus this asset (machine or building) bought is also a part of company’s capital (cash replaced by machine or building). To understand capital in more details visit this page on investopedia.
Formula for calculating ROCE is as below
ROCE= Operating Income/Capital Employed * 100
Operating income (as mentioned above) is nothing but the gross profit minus fixed operating expenses and depreciation. Gross profit, on the other hand, is nothing but the sales minus purchase (or cost of goods).
So basically ROCE is the operating profit (not net profit) generated by the company with respect to the capital employed by the company to run its business operations. ROCE is slightly different from the return on equity (ROE). ROE is the net profit (profit that comes after deducting taxes and interest costs from the operating profit) generated by the company at the end of the year with respect to the total shareholders funds (excludes debt or long term borrowings as these are never the part of the shareholders funds).
The first time money generated by the company through its IPO (initial Public Offering) plus the retained earnings each year is actually considered shareholders funds or shareholders equity.
ROE= Net Profit/Shareholders equity * 100.
You don't actually need to calculate values like ROCE and ROE (unless you are a student) manually. For every stock listed company this data is available on our site. Just make use of the search box above (on this webpage) to search any company name and you will find all the data (including ROCE and ROE) for past 10 years of that company. It's that easy.
Now let’s see what role does ROCE plays in stock investing
Suppose a stock listed company is into manufacturing business. It may be that due to the company’s monopoly products it is able to generate good profit margins from its core business of manufacturing. But it may also be that the company is facing cash flow problem and so the amount with them (as the shareholders equity) may not be sufficient to run their business effectively.
In order to overcome this cash flow problem let us suppose the company took a long term loan from some financial institution ( like a bank) and this loan taken costs them 10% annual interest. This interest (and taxes) will be deducted from the operating profit to obtain the net profit of the company.
Since here the net profit of the company is reduced due to the 10% interest paid, return on equity (ROE) will be much less as and when compared to the return on capital employed (ROCE). This is because we take net profit of the company as the numerator in the ratio of the formula (as mentioned earlier in this article) used to calculate return on equity.
So if the net profit is reduced (due to large interest cost), return on equity will also get reduced which is not a good thing but here ROCE will still be high as we include only operating profit (not net profit) in the numerator of the ratio of the formula used to calculate ROCE.
If company A and B have the same ROCE (see below table) but if one of the companies (say company B) have a heavy debt on it then its return on equity will be much less than the other company which is either debt free or having very little debt.
Comparing the two ratios (ROE and ROCE) gives us a good idea about a company’s profitability or loss. Usually ROCE and ROE greater than 15% is considered good but it’s much better if it is more than 20%. If ROE is much lesser than the ROCE then it simply means high interest cost is eating away the profit margins of the company. When the value of ROCE and ROE are very close (say gap of only 1-3%) it is considered very good as then we may assume there is not much debt on the company.
It’s the debt on a company that makes the huge difference. Some companies have good profit margins in their business (ROCE is good) but the large interest cost hit their profitability due to heavy debt on them (ROE gets reduced). However, if a company is paying its debt on regular basis (QOQ or YOY) then it will surely improve their return on equity and bring it close to the ROCE.
So, if you want to know how a company is doing in it's business provided it was not ladened with debt burden then look at ROCE but if you want to know how actually the company is performing then look at the ROE (the reality).