Return on Capital Employed (ROCE): The Ratio for Profitable Investing

ROCE: understanding the performance of invested capital

Does the company you're considering becoming a shareholder in invest efficiently? The calculation of ROCE, return on capital employed, which can be translated into French as "retour sur investissement des capitaux engagés", can provide an answer. This financial ratio compares a company's profit to the total amount it can invest, whether that comes from the company's own equity or borrowed (debt). I

nvestors prefer the money they put into a company to be as profitable as possible. However, how these funds will be used results from strategic choices, the effectiveness of which can be debated. To estimate if the money is well-used, one approach is to measure the profitability of funds invested in past years. ROCE precisely measures this aspect. This ratio is commonly used in finance to compare the performance of companies from the same sector. It judges the relevance of investments made with the capital available to the company. It is calculated based on annual financial data, by dividing operating income by the sum of debts and equity. This indicator is also valuable for measuring year-on-year changes in a company's investment efficiency.

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How to calculate the ROCE

Just like the EBITDA, which measures a company's gross profit, the ROCE is not an official calculation. In other words, there can be several ways to obtain it. Therefore, its interpretation is subject to caution: before evaluating its relevance, it's better to examine the methodology used. Experienced financiers know that it's possible to interpret the figures in very different ways. The calculation of ROCE starts from the elements of the balance sheet.

The balance always being respected, it's possible to estimate it either by starting from jobs (fixed assets and working capital requirement) or from resources (equity and debt). Let's consider that the EBIT (Earning Before Interest and Taxes) represents the operating result and that Ti represents the tax rate. The economic asset corresponds to the sum of the fixed assets and the working capital requirement.

Starting from the jobs, the indicator is calculated using the formula:

ROCE = ([EBIT] x [1 -Ti]) / economic asset = Net profit after tax / (fixed assets + working capital requirement)

Starting from resources, where the term CI represents the sum of invested capital and net nonoperational assets (i.e., equity and net debt), the calculation formular is as follows:

ROCE = ([EBIT] x [1 -Ti]) / CI = Net profit after tax / (equity + debt)

How to interpret the ROCE

The calculation of ROCE allows to highlight a company's return on invested capital and to approach the profits generated by one euro of used capital. The more profit a company makes, the more profitable it is and can pay its shareholders and creditors. Therefore, the higher a ROCE is, the more a company maximizes the results of its investments. A ROCE of 20%, for example, means that when a company uses 100 euros of its capital to conduct an activity, it achieves a result of 20 euros.

The evolution of the ROCE over the years is also an important performance indicator, as investors favor companies with stable and rising levels of profitability. A good ROCE should thus:
- be higher than its financing cost,
- be better than that of other comparable companies,
- improve over time.

To put the ROCE into perspective, it is important to calculate at least the one of the previous three years.

Calculate and compare using ROCE: example

Here are the financial results of two fictitious companies in the same sector, company Tartampion 1 and company Trucmuche 2. Let's try to figure out which one has the best potential for profitability from funds invested by comparing their ROCE.

Company Tartampion 1 Company Trucmuche 2 Revenue | 100,000 | 100,000
Operating income | 20,000 | 30,000
Corporate taxes | 5,000 | 7,500
After-tax income | 15,000 | 22,500
Fixed assets | 100,000 | 200,000
WCR (working capital requirement) | 15,000 | 30,000
ROCE | = 15,000 / (100,000 + 15,000)
= 13% | = 22,500 / (200,000 + 30,000)
= 9.7%

Both companies have identical revenue and company Trucmuche 2 yields a better profit. If looking only at profitability relative to revenue, it is the most interesting. But the ROCE calculation reveals that the amount of its economic assets (fixed assets + WCR) is significantly higher than that of company Tartampion 1. Therefore, the latter has the best return on invested funds: for every dollar invested, Tartampion 1 generates 13 dollars whereas Trucmuche 2 only generates 9.70 dollars. At first glance, even if its net profit is less significant, Tartampion 1's investments are more efficient. Would they remain as efficient if it invested more? That remains to be seen. Hence, the importance of relying on other analysis elements through financial indicators (price earning ratio or "PER", EBITDA etc.) as well as the economic, competitive context and strategic policy implemented by each of these companies.

What is the usefulness of ROCE in a stock investment

Financial managers and potential investors can use the ROCE when conducting a company's financial analysis. They can also rely on this indicator to compare companies within the same sector with the intention of making a wise investment choice. A publicly traded group must be able to present an enticing ROCE to its current and future investors.

This profitability and good management indicator also provides an idea of the benefits a shareholder may enjoy from investing. It is used to evaluate the relevance of a company's strategy and to determine if it is making sound investment choices. It also informs the shareholder about potential risks of dilution or overpaid assets in acquisition.

What are the differences between ROCE, ROE, and WACC?

The ROCE is often used to compare the performance of companies in capital-intensive sectors like manufacturing, telecommunication, etc. Unlike the ROE (return on equity), which analyzes profitability linked to equity capital, ROCE considers all long-term invested capital. This includes equity, borrowings, and other external contributions integrated into the capital.

This indicator is most often referred to as a company's financial profitability while the ROE depicts exclusively the economic profitability of funds provided by shareholders. Moreover, the WACC (weighted average cost of capital), measuring the average weighted cost of equity and debt, is an indicator that facilitates the analysis of the ROCE. Finance professionals use this indicator to assess a company's profitability.

A ROCE higher than the WACC means that the company is creating value and has a surplus after remunerating creditors and shareholders. On the contrary, if the company's margin is not sufficient to meet the remuneration demands of creditors and shareholders, it is said that the company is destroying value.