How to Use Return on Capital Employed (ROCE) to Select Superior Stocks?

Return on Capital Employed (ROCE) is a type of profitability ratio used in analysing stocks. It analyses how much return a company generates for its investors.

But wait… isn’t that what Return on Equity (ROE) tells you?

No. This is the main difference between ROE and ROCE. As we know, there are two types of investors in a company –

  • Equity shareholders
  • Debt investors (Creditors – Banks, Financial Institutions etc)

ROE calculates the return generated by a company on its equity capital. It does not include returns generated on capital raised in the form of debt. As expected, ROE gives a partial picture of a company’s profitability.

After all, why does a company raise debt?

For growth and expansion, correct?

Then shouldn’t debt be included to calculate a company’s return?

Yes! ROCE also includes debt while calculating a company’s overall returns. Hence it is a comprehensive ratio to measure a company’s overall returns.

Knowing return on capital employed is crucial before you make any investment decision. For example: how will you decide whether to invest your bonus in bank fixed deposit (FD) or mutual funds? You will look at the returns generated by both asset classes. You will invest in whichever asset generates higher returns.

In case of FDs, the return is easily available. But in stocks, you need to calculate the return on capital employed to evaluate whether the stock is worth investing. High ROCE stocks are preferred by investors as it means the company’s management is able to generate superior returns.

In this article, we will explore the following about return on capital employed –

1. What is ROCE?
2. How to Calculate ROCE?
3. How to Analyse Stocks Using ROCE?
4. FAQs on Return on Capital Employed.

Let us begin by understanding what is ROCE.

What is Return on Capital Employed? – ROCE Meaning

Return on capital employed measures the returns generated by a company on its total capital employed. This includes both equity capital and debt capital. Capital employed includes long-term debt and equity share capital. It does not include short-term debt. To evaluate short-term debt, we use liquidity ratios.

Consider the following example:

You have Rs 5 Lakh to invest. Your friends, Raju and Venkat approach you for a loan. Raju runs a hair salon and Venkat owns a garage. Last year, Raju made a profit of Rs 3 Lakhs. While Venkat’s profit was Rs 4 Lakhs.

Based on this information, you will conclude that Venkat’s business is more profitable.

But what if I tell you that Raju’s equity capital is Rs 6 Lakhs and Venkat’s is Rs 10 lakhs?

Now:

  • Raju’s return on capital is 50% (Rs 3 Lakhs / Rs 6 Lakhs).
  • Venkat’s return on capital is 40% (Rs 4 Lakhs / Rs 10 Lakhs).

Now, Raju’s business looks more attractive. But wait… Raju has debt capital of Rs 2 Lakhs. Whereas Venkat’s debt capital is Rs 3 Lakhs.

Let us calculate their real return on capital employed.

  • Raju’s return on capital employed = 38% (Rs 3 Lakhs / Rs 6,00,000 + Rs 2,00,000)
  • Venkat’s return on capital employed = 31% (Rs 4 Lakhs / Rs 10,00,000 + Rs 3,00,000)

Notice how Venkat had higher profits still his ROCE and ROE is less than Raju. This is the biggest blunder that investors make. Just because a company makes higher profits doesn’t mean it will generate higher returns for you.

ROCE measures the profit generated by a company per one rupee of capital employed. For example:

  • The ROCE of ITC Ltd is 32.60%. This means for every hundred rupee of capital employed, ITC Ltd makes Rs 32.60.
  • TATA Motors Ltd has a ROCE of -0.37%. This means the company is losing 37 paise per hundred rupees of capital employed.
  • Modern Steel Ltd has the worst ROCE in India. It’s ROCE is -24,576%. This means the company is making a loss of Rs 24,576 per hundred rupees of capital employed.

It doesn’t take a genius to figure out that a company with high ROCE will generate better returns for investors.

Let us now understand how to calculate return on capital employed using ROCE formula.

Calculating Return on Capital Employed

The formula for calculating return on capital employed is –

ROCE Formula = Earnings Before Interest and Tax (EBIT) / Capital Employed

EBIT is easily available in a company’s profit and loss (P&L) statement. However, there are three ways to calculate capital employed:

  • Capital Employed Formula = Total Assets – Current Liabilities
  • Capital Employed Formula = Fixed Assets + Working Capital
  • Capital Employed Formula = Equity Share Capital + Reserves and Surplus + Preferred Equity + Long term Debt.

The ideal capital employed formula is the last one. It includes all kinds of equity capital plus long-term debt.

Let us calculate the ROCE of Asian Paints Ltd for quarter ending 31st March 2020. We will need the following to calculate ROCE:

As on 31st March 2020, the operating profit of Asian Paints Ltd is Rs 3,583.25 crores. It’s long term debt (listed as non-current liabilities in balance sheet) are Rs 1,240.70. It’s reserves and surplus are Rs 10,034 crores.

Asian Paints Ltd.’s ROCE = EBIT / Share Capital + Long-Term Debt

= Rs 3,583.25 / (Rs 10,034 + 95.92 + 1,240.70)

= 31.51%.

This means, Asian Paints is generating Rs 31.51 per hundred rupees of capital employed.

Is this a good ROCE or poor ROCE?

Well…There is no ideal ROCE. But higher the ROCE the better the investment opportunity. However, the comparison must be in the same sector.

For example:

This does not mean that Adani Green Energy Ltd is a superior stock. When using ROCE, you should always compare within the same industry. Also, ROCE should always be used in combination with ROE and Return on Assets (ROA).

Let us see how to use ROCE to analyse stocks in the personal products sector.

The below table consists of all the stocks in personal products sector. Let us compare their ROCE against other parameters.

StocksS ROCE ROE ROA  Cash  PB PE DE
HINDUSTAN UNILEVER LTD. 39.20% 29.20% 23.90% 4,471 11.80 68.80 0
DABUR INDIA LTD 27.90% 24.80% 22.30% 1,385 13.40 59.60 0.06
GODREJ CONSUMER PRODUCTS 18.60% 20.50% 13.70% 457 8.37 44.70 0.15
MARICO LIMITED 44.30% 37.00% 33.80% 944 18.20 50.60 0.11
P&G HYGIENE & HEALTH CARE 58.30% 42.10% 39.40% 1,266 33.33 65.50 0
COLGATE PALMOLIVE LTD. 67.40% 53.70% 49.80% 761 24.90 43.9 0.06
EMAMI LIMITED 18.20% 15.50% 13.60% 239 12.20 55.60 0.11
GILLETTE INDIA LTD 37.90% 27.30% 25.60% 400 19.10 54.20 0
BAJAJ CONSUMER CARE LTD 37.90% 31.60% 31.20% 983 5.26 17.80 0.01
S H KELKAR AND CO. LTD. 9.61% 6.74% 4.72% 99 2.32 17.60 0.51
CUPID LIMITED 49.80% 44.20% 37.10% 33 2.63 9.29 0.11
J.L.MORISON (INDIA) LTD. 3.10% 2.42% 2.36% 6 1.82 94.00 0
RADIX INDUSTRIES (INDIA) LIMIT 8.59% 8.23% 6.98% 0 3.14 38.80 0.58
ADOR MULTIPRODUCTS LTD. -31.80% -42.80% -35.00% 4 2.58 16.2 0
PARAMOUNT COSMETICS (INDIA) LT 6.93% -0.62% -0.30% 1 0.42 1.02
Novateor Research Laboratories 0.47% -0.16% -0.16% 1 0.40 0
Industry Average 24.78% 18.73% 16.81% 9.99 45.47 0.17

We can conclude the following from the above data:

  • Average ROCE of the personal products sector is 24.78%.
  • Average ROE of the sector is 18.73%. The difference between ROCE and ROE can be due to high cash reserves or debt on balance sheet.
  • The ROCE of Godrej Consumer Products is 18.60%. This is below the industry ROCE of 24.78%. But its ROE is higher than industry average. It also has the lowest price to earnings ratio (PE) of 44.70 in top 10 stocks. It’s average Price to Book Value (PB) at 8.37 is lower than industry average of 9.99. These are all signs of an undervalued stock.
  • Hindustan Unilever Ltd.’s cash holdings are six times the average industry cash holdings. This can also be the reason behind its high ROCE.
  • Cupid Ltd has high ROCE, ROE and ROA. It is also trading at an attractive PE and PB. However, its Debt to Equity ratio (DE) is 0.11. This is twice the average DE of top 10 stocks. Even high DE can inflate a stock’s ROCE. Hence it is better to avoid Cupid Ltd.

Likewise, you can compare and analyse stocks from any industry using ROCE ratio.

Things to Remember About Return on Capital Employed (ROCE)

  1. Trend Analysis: Investors do not want to invest in one-hit wonders. Instead they want to invest in solid companies with consistent ROCE. Trend analysis is the study of long-term financial data of a company to determine a stock’s trend. Ideally, a five-year ROCE trend analysis is sufficient.For example: ROCE of HUL, Dabur India and P&G Hygiene & Healthcare Ltd (PGHH) is way above industry average. But look at their five-year ROCE trend.

Return on Capital Employed_5 Year Trend Analysis

 

  • HUL has shown consistent increase in ROCE.
  • Dabur India’s ROCE has fallen by 26% between 2016-2020.

Now look at the five-year trend of PGHH. Its ROCE jumped 41% between 2017-18. But fell by 19% consistently in 2018-19 and 2019-20. High ROCE volatility is a sign of a highly cyclical industry. Hence investors need to be cautious while investing in cyclical stocks.

[Recommended Read: Best Growth Stocks to Buy in India for 2021]

  1. ROCE in Capital Intensive Sectors: Capital intensive sectors need a lot of capital to set up. For example: Oil refining, steel production, telecommunications etc. A big portion of this capital is financed by debt. Therefore, they have high debt on their balance sheet. High Debt artificially increases ROE. Hence ROCE works better in capital intensive companies as it considers debt. 
  1. ROCE and Weighted Average Cost of Capital (WACC): Return on capital employed should always be higher than WACC.For example: Adani Power Ltd has long-term debt of Rs 49,640 crores. It pays an interest of Rs 5,315 crores. Assume the WACC of all these long-term papers is 10%. This means Adani Power Ltd has to pay 10% interest to its lenders. But its ROCE is 8.22%. Its ROCE is less than WACC. This means the company is earning negative rate of return. This is a potential red flag for investors. Hence ROCE should always be greater than WACC. 
  1. High Cash & Equity Dilution: Enormous amounts of cash is another reason for a high ROCE. Companies often hoard cash instead of investing them in future projects. But cash is included in calculating ROCE. So, higher cash equals higher ROCE. Similarly, a decrease in equity shareholding can increase a company’s ROCE. Hence investors should pay close attention to the reason behind an abnormal increase in ROCE. 
  1. Incorrect Book Value of Assets: ROCE measures assets on their book value. But assets can be easily overvalued or undervalued on a balance sheet. In such cases, return on capital employed will increase without any increase in net profits. This is usually seen in businesses with highly depreciating assets. For example: Steel plants.
  1. ROCE vs Return on Invested Capital (ROIC): The main difference between ROCE and ROIC is that in ROIC we use net profit instead of EBIT. ROIC shows the returns generated by a company after paying taxes, interest and depreciation. It is a stricter form of ROCE.

Summary

To analyse capital intensive stocks, use ROCE instead of ROE. For companies with zero debt, ROE is preferable.  ROE, ROCE, ROIC and ROA are all important profitability ratios that will help you discover diamonds among duds.

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FAQs on ROCE (Return on Capital Employed)

  1. What is the meaning of ROCE in stock market?

ROCE means Return on Capital Employed. It tells you how much return a company has generated on both equity and debt capital. A high ROCE means the management is managing the business efficiently and generating high profits.

  1. What is ROCE formula?

To calculate ROCE, you must divide a company’s EBIT by its capital employed.

  1. What is capital employed formula?

There are three ways to calculate capital employed:

  • Capital Employed Formula #1 = Total assets – current liabilities
  • Capital Employed Formula #2 = Fixed Assets + Working Capital
  • Capital Employed Formula #3: Equity capital + reserves + long term debt + short term debt
  1. What is the difference between ROCE and ROE?

Both ROCE and ROE are profitability ratios. The main difference between ROCE and ROE is that ROE considers only equity capital whereas ROCE considers equity and debt capital both.

  1. What is the difference between ROCE and ROIC?

ROIC is a stricter form of ROCE. It is calculated by dividing net profits by capital employed. Whereas to calculate ROCE, we divide EBIT by capital employed.

  1. What does ROCE indicate?

ROCE indicates the actual returns a company generates on its total capital. For example: The ROCE of Reliance Industries is 8.20%. This means the company is generating a return of Rs 8.20 per one rupee of capital employed.

  1. What is a good ROCE?

There is no ideal or good ROCE. For example: The average ROCE of personal products sector is 24.78%. Whereas the average ROCE of integrated oil and gas sector is 19.4%. However, higher the ROCE the better it is. 

  1. Can ROCE be negative?

Yes, ROCE can be negative. This happens when companies have a negative operating profit. Companies with negative ROCE include Tata Motors Ltd, Vodafone Idea Ltd, BHEL, Hindustan Copper Ltd, MRPL, Nazara Technologies Ltd, Burger King India Ltd, Suzlon Energy Ltd etc.

  1. Is a High ROCE good?

A high ROCE means the company is generating higher returns for their investors. But a high ROCE should be accompanied with high net profit, low debt to equity and non-dilution of equity share capital. A high ROCE does not mean a good stock. You need to analyse other parameters like ROE, DE, PE etc before investing.

  1. Which stocks have the highest ROCE in India?

MFL India Ltd has the highest ROCE of 1,159%. However, the stock is a penny stock and should be avoided! Instead read best penny stocks to buy in India today.

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