ROCE is a measure of how efficiently a company uses its capital to generate profits. It is calculated by dividing the earnings before interest and tax (EBIT) by the capital employed (CE). A high ROCE indicates that a company is able to generate more profits per unit of capital invested, which implies a higher quality of business and a competitive advantage over its peers.
In this article, we will explore why high ROCE companiesare great investments, and how to identify and evaluate them using some examples from the BSE 500 index.
Return on capital employed (ROCE) is one of the most important metrics for investors to assess the quality and performance of a business. It measures how much profit a company generates from every rupee of capital it employs in its operations. Capital employed is the sum of shareholders’ equity and debt, minus cash and cash equivalents. It represents the total amount of funds that a company has invested in its assets and working capital.
ROCE is calculated by dividing the earnings before interest and tax (EBIT) by the capital employed (CE). EBIT is the profit that a company earns from its core operations, excluding the interest expenses and taxes. It reflects the operating efficiency and profitability of a business.
ROCE = EBIT / CE
A high ROCE indicates that a company is able to generate more profits per unit of capital invested, which implies a higher quality of business and a competitive advantage over its peers. A high ROCE also suggests that a company has a strong moat or a sustainable edge that allows it to earn above-average returns on its capital. A high ROCE also means that a company has more free cash flow available for reinvestment, growth, dividends or debt reduction.
A low ROCE, on the other hand, indicates that a company is not using its capital efficiently or effectively, and is earning below-average returns on its investments. A low ROCE may also signal that a company is facing intense competition, declining margins, high operating costs or obsolescence of its products or services.
Therefore, investors should look for companies with high ROCEs as they are likely to be more profitable, stable and growth-oriented than companies with low ROCEs.
How to identify high ROCE companies
There are various ways to identify high ROCE companies. One of the simplest ways is to use online screeners or databases that provide financial data and ratios for listed companies. For example, one can use Screener.in or Trendlyne.com to filter out companies with high ROCEs in the BSE 500 index.
Another way is to manually calculate the ROCE for each company using their annual reports or financial statements. This may be more time-consuming but also more accurate and reliable. One can find the EBIT and CE figures in the income statement and balance sheet respectively. Alternatively, one can use the formula:
ROCE = (Net Profit + Interest Expense) / (Shareholders’ Equity + Debt – Cash)
This formula adjusts the EBIT for interest expense and the CE for cash holdings, which may affect the ROCE calculation.
How to evaluate high ROCE companies
Once we have identified some high ROCE companies in India, we need to evaluate them further to determine their investment potential. Here are some factors to consider:
- Consistency: A high ROCE should be consistent over time, preferably over multiple years or quarters. This indicates that a company has a stable and durable business model that can withstand market fluctuations and competitive pressures. A consistent high ROCE also shows that a company has a strong pricing power and cost control that enable it to maintain or improve its margins and returns.
- Growth: A high ROCE should be accompanied by growth in revenues, earnings and cash flows. This indicates that a company is able to reinvest its profits into expanding its operations, entering new markets or launching new products or services. A growing high ROCE also shows that a company has a scalable and diversified business that can leverage its existing resources and capabilities to create more value for its shareholders.
- Valuation: A high ROCE should be reflected in the valuation of a company’s stock. A high ROCE company should trade at a premium to its peers and the market, as it deserves a higher multiple for its superior quality and performance. However, a high ROCE company should not be overvalued, as it may imply unrealistic expectations or excessive optimism. A high ROCE company should have a reasonable price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, price-to-sales (P/S) ratio or price-to-free-cash-flow (P/FCF) ratio, depending on the industry and the stage of the business cycle.
ROCE is a key metric for investors to evaluate the quality and performance of a business. It measures how much profit a company generates from every rupee of capital it employs in its operations. High ROCE companies are great investments as they indicate that they have a high quality of business and a competitive advantage over their peers.
Investors can identify high ROCE companies using online screeners or databases that provide financial data and ratios for listed companies. One can also evaluate high ROCE companies using factors such as consistency, growth and valuation. We should look for companies that can sustain or improve their returns on capital over time, while growing their revenues, earnings and cash flows at an attractive rate.
Investing in high ROCE companies can help investors achieve superior returns over the long term but one should also be mindful of the valuation of high ROCE companies, and avoid paying too much for their quality and performance.