Businesses take on many different forms, and it’s often difficult to compare them to one another, especially when they operate in different industries.
This is where financial metrics come in handy. Many of them can tell you something useful about a company without you having to understand all the ins and outs of what it does.
While you should always do as much research as possible when investing in businesses, simple metrics like the price-earnings ratio, price-earnings to growth ratio, current ratio and debt-to-equity ratio can help you sort the companies that may be promising from those that you can discount quickly.
Today, we will look at another useful metric: return on capital employed (ROCE)
What is it?
ROCE is calculated by taking earnings before interest and taxes (Ebit) and dividing that figure by the sum of the long term liabilities (but not short-term debt) and equity of a business. You can also express it in a different (but equivalent) form as "Ebit divided by total assets minus current liabilities." It is generally expressed as a percentage.
At its core, ROCE is a measure of efficiency, and it measures how good a business is at utilising its capital to generate earnings. It seeks to answer the ultimate question for every investor: “how much will I earn if I put my money into this asset?”
What is it for?
ROCE is useful because it combines information from both the balance sheet and the income statement, whereas a lot of other ratios and metrics are concerned with one or the other. All financial statements need to be interpreted as a whole, rather than separately, so you can see why a metric like ROCE is a good one to use.
ROCE is most useful when analyzing companies in capital heavy sectors like manufacturing, energy, telecommunications or other such industries. This is because there is a more direct and tangible relationship between the amount of capital that you put in and the output that it generates. By contrast, companies with large amounts of intangible assets are harder to value using ROCE - for instance, a software startup which has little in the way of hard assets will have a lot of confounding factors that won’t be accounted for by ROCE.
Nevertheless, I think it is an excellent ratio that all investors should be familiar and comfortable with, and it can give you reasonably accurate estimates for a company’s capital usage efficiency, especially when compared to more crude metrics.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Buffett, Munger Explain the Most Important Metric to Look for When Investing
- Charlie Munger: Know When to Take Advantage of Investment Windows
- The Value Investor’s Handbook: The Price-Earnings to Growth Ratio​
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