When you analyze companies to invest in them, you have to look at many aspects, such as income, profits, future projections … and among that conglomerate of data there are one quite interesting which is the ROCE.
The ROCE indicates the profitability of the company on the capital employed, for its acronym in English: Return On Capital Employed. And it is key to determining whether or not a business is capital intensive, which can be a problem in generating future income.
How is ROCE calculated?
Calculating ROCE is relatively straightforward. On the one hand you have to have the profit of the company before taxes and interests (EBIT or gross margin) and on the other the capital employed (the assets used by the company). The division of both values expressed as a percentage is the ROCE:
ROCE = EBIT / Capital empleado x 100
Having the EBIT is relatively easy, it is the gross margin and it is provided in the income statements. The capital employed would be the assets (capital plus debt) minus current liabilities (short-term debts such as unpaid bills), both values also provided in the accounts.
For example, if a company has a gross margin of € 1 billion and an employed capital of € 10 billion, its ROCE will be 10%. That is to say, ROCE provides a measure of return on equity.
Corrections are sometimes made in the ROCE calculation. For example, a very profitable company may have a lot of cash but does not do anything with it (an example of this would be Apple, although lately it takes advantage of it to buy back shares). But really that capital, which is part of the definition of capital employed, is not used for the business and therefore it is more convenient to exclude it to have a tighter view of the real ROCE of the company.
Advantages of having a high ROCE
A high ROCE (for example, above 20%) and sustained over time indicates good business health. We would be facing a company that is capable of extracting a good profitability from the resources it has and therefore is definition of a good investment.
Normally there are sectors with higher ROCEs than others and therefore it is usually convenient not to exclusively compare the ROCE between two very different companies. Producing cars is not the same as providing services on the Internet. The first business needs much more capital and therefore its ROCE should be lower.
But within a specific sector, having a higher ROCE than other companies on a sustained basis does indicate that the quality of the company is better than that of its competition and therefore it should be valued to invest in it.