One of Terry Smith’s investing foundations’ main pillars is to invest in good companies that he defines by companies with high returns on capital employed. For those of you not familiar with Smith, he runs Fundsmith, whose returns have almost doubled the returns of the S&P 500 over the last decade.
Smith’s Fundsmith has investments that have averaged over 29% since 2010. Return on capital employed, also known as ROCE, is similar to return on invested capital. It helps investors determine how effectively a company uses its assets to drive revenues and profits.
The better or more efficiently a company reinvests its assets, the better the returns will be over a long period. Charlie Munger on return on capital:
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”
In today’s post, we will learn:
- What is Return on Capital Employed?
- How Do I Calculate Capital Employed?
- What Does Return on Capital Employed Indicate?
- What is a Good Return on Capital Employed?
- Investor Takeaway
Okay, let’s dive in and learn more about return on capital employed.
What is Return on Capital Employed?
Return on capital employed, per Investopedia, means:
“Return on capital employed (ROCE) is a financial ratio that can be used in assessing a company’s profitability and capital efficiency.”
The easiest way to think about this ratio is to tell us how efficiently a business deploys its capital. Or how well it generates profits from its equity. Remember that the company’s equity is a combination of the shareholders’ equity and long-term liabilities, i.e., debt.
Both shareholders’ equity and debt help a company purchase assets that they can then use to drive profits. For example, Amazon’s retail segment of the business carries an inventory of millions of items, and they may purchase that inventory from either equity in the company or debt. They then turn around and use that inventory to drive more revenues. In Amazon’s case, because the company is profitable, those revenues flow to net income, which becomes retained earnings, part of shareholder equity, for the company, which allows them to buy more inventory.
Return on capital employed is a profitability ratio that tells us how efficiently they turn their capital into operating profits. ROCE is very similar to return on invested capital (ROIC), and many companies use those two ratios plus return on equity (ROE) and return on assets (ROA) to measure their performances.
Before digging into return on capital employed, refer to the below links to learn more about the ratios mentioned above if you are unsure of how they work:
Let’s look at a flow chart to illustrate how this concept works before digging into the ratio calculation.
From the above illustration, we can see how the equity and debt purchase the fixed assets and cash, which flows to the production of goods and services that flows to the sales, which drives expenses and operating income.
And with our return on capital employed ratio, we can measure how effective that flow is for the business.
How Do I Calculate Return On Capital Employed?
The most traditional way to calculate return on capital employed is:
ROCE = EBIT / Capital Employed
- EBIT equals earnings before interest and taxes, or operating income.
- Capital Employed equals total assets minus current liabilities
The EBIT or operating income tells us how much profit a company makes after subtracting the cost of goods sold and operating expenses such as payroll, R&D, and SG&A from revenues. EBIT is also exclusive of the impacts of taxes and any interest expenses or interest income, so it solely stems from its operations.
Capital employed, which is quite similar to invested capital from the ROIC ratio, is from subtracting total assets from current liabilities. That subtraction gives us shareholders’ equity and long-term debt, which the company uses to drive revenues and profits, from the above example.
Some analysts like to use an average of capital employed, which means they calculate it for a period measured between two periods.
We can also use net operating profit in place of EBIT, or we can also use NOPAT from ROIC if you choose. The main issue is to remain consistent with your usage of different metrics.
Okay, let’s calculate the ROCE for a company to see how this works, and for our guinea pig, I would like to use Intuit (INTU), and I will take the info from the latest 10-k, dated July 31, 2020. And I will pull the info from the actual financial statements to calculate our ratio.
EBIT for Intuit in 2020 and 2019 equals:
- 2020 – $2,716 million
- 2019 – $1,854 million
Total assets and current liabilities for Intuit:
- 2020 Total Assets = $10,931 million
- 2019 Total Assets = $6,283 million
- 2020 Current Liabilities = $3,529 million
- 2019 Current Liabilities = $1,966 million
Now, we can plug all the info into our ratio to determine how efficiently Intuit uses its capital.
That was pretty simple, huh?
To give it further context, it is best to compare the return on capital employed to others in the company’s industry. To compare Intuit, let’s look at some of its peers, using TTM numbers as of April 7, 2021, all numbers in millions unless otherwise stated:
- Zoom Video (ZM)
- Autodesk (ADSK)
- Workday (WDAY)
As we can see from above, Intuit is the second-highest performer in their peer group, while Workday is the lowest. Of course, most of the periods reported for this sample are from the Covid year, which will skew the numbers. Another great example of using this ratio is to look at it over a longer period, so for Intuit, I will put together the numbers over the last ten years to get an idea of how the company is doing.
Digging deeper, we see that the average for Intuit over the ten years recorded:
Average = 39.28%
Median = 36.69%
All of which tells how the company did in the last twelve months compared to both its historical average and median, and we can easily see the impact that Covid might have had on Intuit. Of course, that is without digging deeper into the company’s financials, but that is the point. It gives us a question that we need to answer before deciding to invest in Intuit.
Just for giggles, let’s look at the NOPAT for Intuit to compare it to the EBIT to see how much impact it might have on the return on capital employed.
- TTM EBIT = $2,060 million
- TTM Tax rate = 17.83%
- NOPAT = 2,060 * (1 – 17.83%) = $1,692
- Total Assets = $14,598
- Current liabilities = $2,677
- ROCE = 14.19%
When comparing to the operating income ROCE of 17.70%, we see the impact that taxes have on Intuit’s operating income.
If you want a more conservative number, using NOPAT will give you a lower ROCE and might be a good comparison to ROIC, which for Intuit was 25.55% for the TTM.
What Does Return on Capital Employed Indicate?
The return on capital employed tells us how much operating income or NOPAT is created for each dollar of capital employed by Intuit. For example, the company’s latest TTM numbers indicate that Intuit drives 17 cents of operating income for every dollar of capital employed. And for the average over the last ten years, the company produced 39 cents of operating income for every dollar of capital employed.
If we look at the other profitability ratios of Intuit over the same period:
- ROE = 31.55%
- ROA = 17.58%
- ROIC = 25.55%
- ROCE = 17.70%
All the above numbers, except ROCE, are from gurufocus.com.
Those numbers tell us that Intui is a profitable company across all metrics. The most important relationship is comparing it to the WACC (weighted average cost of capital), which tells us how much capital we measure costs the company.
If the company is creating value, all the above profitability metrics will be higher than its cost of capital; if it is below that cost of capital, it indicates the company is destroying value with its capital.
As we discovered by calculating the ROCE ratio, we determine how efficiently Intuit uses its capital to grow its operating income. If the cost of that capital exceeds the ROCE, it is too expensive for the company to expand because that cost is higher than its returns, making those expansions unprofitable.
What is a Good Return on Capital Employed?
The answer depends on the company and industry the company operates. For example, comparing the ROCE for Exxon to Apple is not a great idea. Apple is a capital-light company, where Exxon is a capital-heavy company, and the method they use to grow operating profits are different.
Instead of looking for a blanket rate such as 20%, it is better to look at your companies ROCE over a longer period, such as five to ten years, and to compare them to others in the same industry. For example, compare Exxon’s to BP, Chevron, and BP and see how your company stacks up compared to its peers.
In the example earlier with Intuit and its peers, Intuit was slightly below Autodesk but ahead of Workday by quite a bit. Then we see that Intuit is performing well compared to its peers, while Workday is underperforming. If we were analyzing Workday, it might be worth looking at the companies’ performance over a longer period to see if that one year was an anomaly or a sign of something bigger.
Generally, we want a higher number because that indicates more profitability. For example, we looked at Intuit throughout this post, but the ROCE for Albemarle, the lithium miner, is 5.18%, lower than the companies WACC of 9.65%. We are keeping in mind that the company is a far more capital-intensive business than Intuit, and it’s subject to commodity prices which causes fluctuations in revenues.
With the proliferation of tech stocks and capital-light industries in today’s markets, the ROCE ratios will be higher than those in more capital-intensive industries.
When trying to decide if your company is profitable, it is best to consider what industry it operates in and compare its performance to others in its peer group. But in general, the higher, the better.
Some industries will naturally have higher returns on capital employed, but a good rule of thumb is to look for two things:
- A return higher than 10%
- A return higher than twice the 30-year Treasury rate, which is 2.35% as of 4/7/21, giving us a rate of 4.7%
The formula for ROCE is simple, and it doesn’t take long to calculate it, I mention this because except for gurufocus.com there is no financial website I have found that lists it as a metric to use as a screen. Despite that fact, it is a great ratio to add to your toolkit when analyzing any company.
Returning to Terry Smith, who we started the post with, his current portfolio sports ROCE ratios of 25% at the end of 2020. That is a great place to start to analyze your portfolio and the companies you are eying up. Keep in mind the breakdown of his portfolio is:
- Tech = 28.9%
- Consumer Staples = 27%
- Healthcare = 22.6%
- Consumer Discretionary = 10.1%
- Communication Services = 4.5%
- Industrials = 3.4%
- Cash = 3.5%
The tech sector’s interesting aspect is the largest, but if you add up the next three, they outweigh the tech sector, and none of those would be classified as “growth” by most investors. I am trying to make that you don’t have to buy only tech to experience growth, and using ROCE can help you find profitable companies in any sector.
Return on capital employed, like return on equity and return on assets, is simple to calculate, but it offers a different way to analyze your companies. It allows you to see how well a company uses its capital to create profits because it flows to operating income, which is a great place to see how profitable your company is from its operations.
Another reason return on capital employed is a great ratio is that it encompasses its debt, where the return on equity does not. And depending on that company, debt helps amplify the returns a company earns because debt can help fund those projects or products that help the company grow revenue, which flows to the operating income.
The more efficiently the company employs its capital, the greater revenue growth. And if the company is operating on all cylinders in its operations, that revenue growth will grow its operating income and net income. All of those factors lead to share appreciation as Wall Street sees the company is growing revenues and earnings, which helps the price grow.
And with that, we will wrap up our discussion for today. As always, thank you for taking the time to read today’s post, and I hope you find something of value in your investing journey. If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,