- Equity shareholders
- Debt investors (Creditors – Banks, Financial Institutions etc)
|1. What is ROCE? 2. How to Calculate ROCE? 3. How to Analyse Stocks Using ROCE? 4. FAQs on Return on Capital Employed.|
What is Return on Capital Employed? – ROCE MeaningReturn 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).
- 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)
- 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.
Calculating Return on Capital EmployedThe 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.
- EBIT or Operating profit – Available in P&L statement
- Equity and Debt Capital – Available in Balance Sheet
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.
|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|
|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|
|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|
|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|
- 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.
Things to Remember About Return on Capital Employed (ROCE)
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
SummaryTo 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.However, there are 2 million more such points. Only after passing through all of them does a stock truly qualify as the best stock! As you can guess, this is real hard work.Fortunately, Samco clients don’t have to do such hard work. They can truly enjoy their lives having trusted Samco with their stock investments. At Samco, every stock in India is tested on 2 million data points. You can check whether the stocks in your current portfolio are good, bad or ugly using Samco Stock Rating. It’s absolutely FREE!No one in the country does such an extensive research. This is precisely why Samco customers are the happiest!You too can skip all this hard work by opening a FREE Samco Demat and trading account. All you need to do is spend 5 minutes filling this account opening form and then let the relaxation begin!
FAQs on ROCE (Return on Capital Employed)
- What is the meaning of ROCE in stock market?
- What is ROCE formula?
- What is capital employed formula?
- 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
- What is the difference between ROCE and ROE?
- What is the difference between ROCE and ROIC?
- What does ROCE indicate?
- What is a good ROCE?
- Can ROCE be negative?
- Is a High ROCE good?
- Which stocks have the highest ROCE in India?