Return on capital employed (ROCE) is a term used by many analysts to quantify a company’s performance. It tells how much profit a company generates after all the capital it uses to produce its goods is taken into consideration. Therefore, ROCE tells us how much profit a company makes per dollar invested, or how profitable it is with its capital employed.
While we watch all kinds of companies make money, investors are always looking for a few companies that can consistently achieve higher returns on their capital. They are looking for companies that can deliver strong returns on the money they invest in their business, and in turn, they want to see their money go further. The companies that consistently deliver the best return on capital are those that reinvest their profits and pay their investors a good dividend. That is why investors look at companies’ return on capital employed (ROCE) as an essential metric for informing their investment decisions.
One of the most common questions in finance is: ‘what is Return on Capital Employed (ROCE)?’. It is an indicator of a company’s profitability. It measures the profit of a company based on the money it has invested in its capital, or simply, how efficiently it is using capital to make money..
The topics we cover in this post are the following,
- Formula and calculation
- How is the NOPAT calculated?
- How do you calculate the invested capital?
- Conceptual and interpretive formula and conclusive thinking
What is Return on Capital Employed
1. Formula and calculation
Return on invested capital, as the name implies, is the return on all the capital that a company uses for its operations during a certain period of time. It is often used in the financial and investment world as a measure of profitability. While it was not widely used 30 years ago, it has come a long way and has even become the focus of some portfolio managers and individual investors.
ROCE is calculated as net operating profit after tax (NOPAT) as a percentage of total long-term invested capital.
Return on Invested Capital = NOPAT / Total Invested Capital
Since NOPAT is earned over the course of the financial period and invested capital is a balance sheet item and generally reported over a period of time, some investors argue that using ROCE based on average invested capital over the period is a better measure.
The calculation is as follows
Return on invested capital = NOPAT / average invested capital
Average invested capital = (initial invested capital + final invested capital)/2
The denominator of the above expressions implies that ROCE can also be defined as the income generated by the firm as a whole or, alternatively, as the income generated by the capital contributed jointly by the firm’s creditors and shareholders.
If the debt component is very low, ROCE should yield a value closer to ROE than for a highly indebted company, assuming comparable sales.
2. How do I calculate NOPAT?
NOPAT (Net Operating Profit After Tax) is calculated on the basis of two important elements: the EBIT and the tax rate. In India, the corporate tax rate is about 30% for companies with a turnover of more than ₹250Cr and about 20% for companies with a turnover of less than ₹250Cr.
The calculation of NOPAT is quite simple and can be done using the equation below,
NOPAT = Earnings before interest and taxes (1 – corporate income tax rate)
NOPAT = (profit before tax + interest payments + one-off adjustments) (1- corporate tax rate)
The black box in this equation is one-time adjustments, which include income and expenses that are not regularly incurred in the course of a business activity. These may include legal fees, losses/gains on sale of assets, gains/losses on revaluation of inventories, etc.
(However, if the company regularly incurs such expenses or makes a profit, this requires further investigation by the investor.)
3. How to calculate invested capital
The calculation of the denominator of the equation is quite simple and can be done on the basis of the balance sheet items of the company.
Since, as mentioned above, the capital used refers to the total capital raised by the company’s debt and equity investors, the formula should reflect the contributions of both capitals to the company’s assets.
Invested capital = total assets – total current liabilities.
It can also be displayed as,
Capital employed = Share capital + Long-term debt
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4. Concept and interpretation
Most investors in the financial world want the company they want to invest in to have a ROIC that is higher than the weighted average cost of capital or WACC. The WACC is defined as the minimum return that a company should achieve given its unique capital structure.
When a firm’s ROCE is higher than its WACC, the firm is considered to be generating value for its shareholders and shareholders are encouraged to hold the firm. If a firm’s ROCE is lower than its WACC, the firm is considered to be destroying value for shareholders, and since shareholders are last in the pecking order, it is recommended that shareholders stay away from such a firm.
Calculating the WACC, or the minimum rate of return a company must achieve, is somewhat difficult, but a non-financial investor can instead compare ROCE to get their own required rate of return.
Since most retail investors are likely unfamiliar with the calculation and specifics of the WACC, we believe it is helpful to use the following rule of thumb to determine your own required rate of return.
Required rate of return (%) = (risk-free bond rate + inflation rate + market risk premium) Safety margin
If the market risk premium refers to the extra premium an investor can expect to pay for investing in the markets, then in most cases it is best to take a value between 3% and 5%.
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Suppose the interest rate on 10-year Indian government bonds is 8.2 percent, inflation is about 8 percent, the market risk premium is 3 percent, and the margin of safety is 20 percent,
Required rate of return (%) = (8.1+8+3) 1.20= 19.1 * 1.20 = 22.9
If a company’s return on capital employed (ROCE) exceeds 22.9%, it means that the company is creating value beyond the ROCE calculated above and could be a target for an investment list.
ROI is not entirely reliable, but it does provide a lot of information about a company’s business model. Moreover, an investor can gain more insight by comparing the dynamics of ROCE value over the last 5-6 years of the company’s operations to form an opinion.
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Return on Capital Employed (ROCE) is a metrics that is used to measure the efficiency of a company by comparing it to the average company in a similar industry. That is, is the company making a profit over the long term and is it making less or more than the average company in the same industry?. Read more about negative return on capital employed and let us know what you think.
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