Return on Capital Employed (ROCE)

It is a profitability metric that assesses how efficiently the company invests money back into the business.

The return on capital employed (ROCE) is a profitability metric; it assesses how efficiently the company invests money back into the business.

Return On Capital Employed Roce

It is an excellent measure of company profitability as it tells how much return the capital employed in the business generates in a given year. Also, it provides an effort to assess the company's capital efficiency.

A high and consistent ROCE tells us that the business has some competitive advantages set up, allowing them to generate higher returns on its capital.

Competitive advantage or 'moat' allows the business to generate Roces higher than the industry average and much above its cost of capital.

A high return on capital employed also translates to higher free cash flows as the EBIT grows.

Formula

There are two components to the ROCE formula:

Capital Employed:

Formula

The capital employed is when current liabilities are subtracted from the total assets. Another way of calculating capital employed is to add the shareholder's equity and long-term liabilities.

In other iterations, the capital employed can be defined as the sum of fixed assets and working capital. Working capital is the difference between current assets and current liabilities.

EBIT:

Formula

The earnings before interest and taxes are arrived at when the interest expenses are added back to the before-tax profits of the firm. In other words, EBIT is the income statement element that comes once the COGS and operating expenses are deducted from the revenues.

The EBIT eliminates the tax effect, making businesses with different tax regimes comparable and leaving out the interest component to account for the company's debt holders and creditors. It shows the amount remaining for the coverage of interest expenses.

ROCE also aids in judging how efficient the company is in using the capital available at its disposal.

It serves as a benchmark for evaluating management quality. The most important aspect for a business to grow is efficient capital allocation. If the managers are not good capital allocators, the company won't be able to grow.

Understanding Return on Capital Employed

The ROCE can either be used as a standalone metric to judge the business empirically or as a relative metric to compare two similar companies.

The reason returns on capital employed are so widely used and accepted as a metric is that it is straightforward to calculate. This metric is most useful in capital-intensive companies. And, unlike any other Return metric, it also incorporates the debt in the quotient and equity.

All the components are audited and straightforward numbers. However, they are challenging to manipulate as well.

Points

The capital employed part is all balance sheet components which are much more challenging to fabricate than the income statement.

The EBIT is more preferred to earnings as it is unaffected by line items such as tax and other adjustments to the net income. It also judges the company's ability to pay its debtors.

ROCE can be used to judge the quality and cyclicality of the business.

If ROCEs is high and consistent, then it is safe to assume that the business is either a quality business with substantial competitive advantages or has very high tailwinds and demand growth that it can consistently generate and reinvest at a very high rate.

Businesses with competitive advantages generate very high returns much above their cost of capital for extended periods.

The business is cyclical if the ROCEs constantly change with higher and lower return periods.

For cyclical industries, contraction and expansion of demand are the key drivers of returns on capital employed. On the other hand, for sectors like steel, automobile, etc., a strong economy and credit availability are crucial to generating high returns on its capital.

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If the business cannot generate returns on capital above its cost of capital, it is said to have average profits. But, if the business can generate them above its cost of money, it is said to have supernormal or economic gains.

Businesses with lower capital requirements usually generate the highest returns on capital employed as they don't need as much money to drive growth. New-age technology businesses are the best examples of that.

Calculating Return on Capital Employed

Exhibit 1: Standard & Poors Global (SPGI) vs. Moody's Corporation (MCO)

S&P Global and Moodys are credit rating agencies based out of the United States. These are the largest credit rating agencies in the world.

They have essentially the same business and thus are very comparable.

Moody's Corporation.

Annual Report

Operations

EBIT is calculated by adding interest expenses to before-tax profits.

EBIT Calculation
(Figures in million $)202120202019
Before-tax profits275522291810
Interest expense171205208
EBIT292624342018

The EBIT for the year 2021 is $3 billion.

Option

Capital employed is calculated by subtracting current liabilities from total assets.

Capital Employed Calculation
(Figures in million $)20212020
Total Assets1468012409
Total Current Liabilities24962222
Capital Employed1218410187

The capital employed for the year 2021 is $12 billion.

ROCE = EBIT / Capital Employed

ROCE Calculation
(Figures in million $)20212020
EBIT24342018
Capital Employed1218410187
ROCE20%20%

Moody's corp has a ROCE of 20% for the years 2021 and 2020

Standard & Poor Global Inc.

Annual Report

Report

EBIT:

EBIT Calculation
(Figures in million $)202120202019
Before-tax profits416432282930
Interest Expense119141141
EBIT428333693071

S&P Global has an EBIT of $4.2 billion for 2021

Annual Report

Report

Capital Employed:

Capital Employed Calculation
(Figures in million $)20212020
Total Assets1502612537
Total Current Liabilities38153587
Capital Employed112118950

Capital employed was $11.2 billion for the year 2021

ROCE = EBIT / Capital Employed

ROCE Calculation
(Figures in million $)20212020
EBIT42833369
Capital Employed112118950
ROCE38%38%

S&P Global has shown a return on capital employed of 38% for the years 2021 and 2020.

Comparing the two companies, it is clear that S&P is the superior firm; it has lower capital employed than Moody's for both 2020 & 2021 and yet has generated almost twice the EBIT.

This means their Capex requirement is much lower because of their competitive advantages.

When we look at the valuation of these firms, we can see

MCO P/E: 24.85

SPGI P/E: 23

Both companies are trading at similar valuations despite S&P having a clear competitive advantage with higher capital returns.

S&P Global is cheaper than Moody's despite having similar valuations due to its superior returns on capital employed.

Exhibit 2: Johnson & Johnson (JNJ) vs. Pfizer Inc. (PFE)

Johnson & Johnson and Pfizer are two of the largest pharmaceutical companies in the world

Johnson & Johnson

Annual Report

Statement

EBIT Calculation
(Figures in million $)202120202019
Before-tax profits227761649717328
Interest Expense183201318
EBIT229591669817646

JNJ has an EBIT is $23 billion for 2021

Annual Report

Statement

Capital Employed Calculation
(Figures in million $)20212020
Total Assets182108174984
Total Current Assets4522642493
Capital Employed136882132491
ROCE Calculation
(Figures in million $)20212020
EBIT2295916698
Capital Employed136882132491
ROCE16.77%12.62%

Pfizer

Annual Report

Report

Pfizer has not shown any interest expense on its income statements, so before tax profits, the EBIT

EBIT Calculation
(Figures in million $)202120202019
Before-tax profit / EBIT24311703611321

Pfizer has an EBIT of $24 billion for 2021.

Annual Report

Report

Capital Employed Calculation
(Figures in million $)20212020
Total Assets181476154229
Total Current Liabilities4267125920
Capital Employed138805128309

Pfizer has a capital employed of $138 billion for 2021

ROCE Calculation
(Figures in million $)20212020
EBIT243117036
Capital Employed138805128309
ROCE17.51%5.48%

J&J has a return on capital employed of 16.77%, and Pfizer stands slightly higher at 17.51%. But JNJ had shown a higher ROCE in the past, while Pfizer has not been able to generate that level of return on its capital in 2020.

At the same time, JNJ boasts a higher valuation than Pfizer at a P/E of 22, while PFE only has a P/E of 10.

The two firms can be said to be valued relatively because Johnson & Johnson has more consistent returns on its capital, it can be argued that Pfizer is undervalued looking at the drastic improvement of its return ratios, but they need to sustain to give the stock a premium.

Return on Capital Employed vs. Return on Invested Capital

ROIC & ROCE are metrics used to judge the profitability of the business. There has been a long-standing argument on which metric is better suited to feeling the actual profitability of a business. ROIC is calculated by dividing invested capital by the net operating profits after taxes (NOPAT).

NOPAT is EBIT after cash taxes are deducted from it.

Formula

There are several approaches for calculating the invested capital. One approach considers invested capital as the non-cash net working capital added to fixed assets.

Formula

Another approach is to use the company's total debt and equity as invested capital.

Formula

But this approach is similar to the ROCE formula with the difference in the inclusion of short-term debt.

Two other methods build upon the previous formulas:

Formula

ROCE & ROIC are very similar ratios; ROCE uses capital employed, and the business's total assets are subtracted from the current liabilities. Therefore, the long-term debt and total equity can alternatively calculate; it will have the same numerical result.

The capital employed is a much broader metric that encompasses long-term debt and equity, the money the business uses.

ROIC, on the other hand, is a more advanced metric. A significant difference is that ROIC used NOPAT is believed to be a better metric than the EBIT as it encompasses cash taxes which is another thing that differentiates the two ratios.

The exclusion of taxes makes businesses with different tax regimes comparable.

ROIC is a much more flexible metric that can be calculated in many different formulas; its versatility makes it more widely accepted than the return on capital employed.

On a comparative basis, the metrics are very similar; ROCE captures a broader metric and is more comparable due to ignoring cash taxes.

ROIC, on the other hand, is a more focused and dynamic metric that can be altered and changed according to different businesses. Even though it includes taxes, corporate tax rates are more or less similar countrywide, with some exceptions.

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Researched and authored by Aditya Salunke I LinkedIn

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