What is ROCE?
ROCE stands for return on capital employed which means the return promoters are able to generate from the cash or capital being deployed in the business. It is a way to measure the efficiency of the management which deploys the cash at better than money market rate for an elongated period of time.
Higher ROCE means better efficient management which means better profitability for the business and the company in the long run.
The textbook formula for ROCE is
ROCE = Earnings Before Interest and Tax (EBIT) / Capital Employed
Though the textbook formula for ROCE has EBIT and Capital Employed by the business, the actual formula can vary from industry to industry and depends on what may be considered as the capital being employed or part of EBIT.
Some websites use the capital work in progress or CWIP for the sake of calculation whereas others use only the working capital. Some consider EBIT whereas other may remove the tax from EBIT as well. Read about EBITDA here.
There is no right or wrong in using either of them but what is more important is to be consistent in the calculation.
Like for example, the ROCE of Page Industries as per ValueResearchOnline for March 2018 is 64% and has been above 60% for each of the past 6 years.
Whereas it is 59% as per the MoneyControl and has a lot of variations as well.
Neither of them is wrong as long as they are doing the calculation consistently.
As an investor, it is important that you follow anyone on a consistent basis. I use these 7 sites and for ROCE, the value of Screener and ValueResearchOnline are consistent and I like to use ROCE right at the first step of my stock selection. So I use Screener’s value. Feel free to use any one of the values for your choice.
Why ROCE is important?
ROCE helps investors understand the kind of profit a company will generate based on the capital it has invested. So the most important aspect to any business is to be able to generate returns than keeping the money in the debt market.
If a business takes a debt at 9% interest, it should be able to generate returns better than 9%. ROCE is a way to measure exactly that and this is the sole reason ROCE is one of the important aspects to measure the efficiency of the business and more importantly the management.
So it is one of the most important factors to consider doing a business in the first place because if the business can’t generate returns better than other avenues of investments, there is no point in doing the business at all.
Similarly, for an investor, the important part of investing is to be able to generate returns and if the business isn’t able to generate returns, investors can never make money in the long run. So it is an important aspect to consider when investing. Same has been emphasized in the books The UnUsual Billionaires and The Little Book That Still Beats the Market.
Good, Average and Ugly ROCE
There are some companies where you won’t see good ROCE value and they are to be avoided. There is no general rule as to what level of ROCE is better than others but the general consensus of 15%+ is a good ROCE level for a business based on the long-term average interest rates in India.
I like to see ROCE be atleast in the double-digit to be considered for investing because if the value is in single digit, it is better to keep the cash invested in the debt market than to invest in a business.
So for me, the good ROCE is above 15%. In all my investment, I like to have an ROCE of above 15% mark.
Note: In the early stages for any business, ROCE may not be very high or in some cases where a company has done fresh investments, ROCE may drop significantly. So it is always better to see ROCE for an elongated period of time.
The average ROCE is between 10 to 15% but I like to see it inching higher. (Force Motors, Lupin are the couple of companies in my portfolio where ROCE is below 15%. Lupin only in the last fiscal had an ROCE of under 15%. Force motors had an increasing ROCE when I first invested but as of now has taken a nose dive).
Needless to say, the ugly ROCE is when it comes in single digit. The average return on the capital deployed in the business is under the average return the cash can generate from the debt market. One of the examples is Bharti Airtel which as per screener has a ROCE of 7.5% only.