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How to calculate the metric and what it means

In previous parts of this series we have looked at a range of valuation metrics, many of which are a good starting point when researching a stock.

To delve a little deeper into a company’s genuine worth there is merit in reaching for a measure that is often employed by fund managers and investment analysts – the return on capital employed (ROCE).

To generate value for its shareholders a business should be looking to generate a ROCE which is consistently ahead of its weighted average cost of capital (WACC).

Translated into plain English this means it needs to make a bigger return on the money spent funding the business than the average cost of that funding (from both debt and equity).

A good rule of thumb is that a ROCE of 15% or more is reflective of a decent quality business and this is almost certain to mean it is generating a return well above its WACC.

HOW TO CALCULATE THE ROCE

A ROCE is made up of two parts – the return and the capital employed. The most widely used measure of return is operating profit.

The capital employed bit is the money needed to keep a business running and can be measured by combining shareholders’ funds with debt liabilities. (Though there are alternative ways of calculating capital employed.)

Shareholders’ funds, also known as total equity or shareholders’ equity, encompasses all a firm’s assets both tangible (such as a factory) and intangible (anything from a brand to a piece of intellectual property) minus any liabilities.

You can find both the shareholders’ equity and a company’s non-current liabilities, an effective proxy for its interest-bearing debt, in the annual accounts statement.

WHAT DRIVES A HIGH ROCE?

Companies with a high ROCE often have relatively modest capital requirements to fund their growth. This might be because their business is largely conducted online so it doesn’t have the overheads associated with, for example, maintaining and adding to a physical footprint. Online second-hand car marketplace Auto Trader (AUTO) is one example.

Franchise businesses, such as Domino’s Pizza (DOM), often command a high ROCE as franchisees take on a decent chunk of the capital burden. The higher returns generated by these businesses often attract a premium valuation.

If a ROCE is rising it tells you one of two things about a business. The return is going up faster than the amount of capital employed, or the capital employed itself is being reduced.

Boosting the return could be achieved by the launch of a successful new product or service which doesn’t come with lots of additional costs or thanks to a change in strategy. Reducing capital employed is a question of cost cutting or potentially scaling back the amount invested in the business.

The problem with reducing investment in the short term is it often stores up costs for the future as investment is required to maintain a strong competitive position or keep up with industry changes.

Even if the increase in ROCE is driven by advancing returns this can draw competition, attracted by the bumper returns on offer, which in turn puts pressure on what a firm charges its customers as it reacts to the competitive threat.

SUSTAINING STRONG RETURNS

For this reason investors should not look at the ROCE for a single year in isolation but should instead examine the performance on this measure over a five or 10-year period to ensure the figure is not being flattered by a one-off bit of lucrative work or by significant costs being taken out of the business.

To deliver sustainably high returns a company likely needs to operate in a market which has strong barriers to entry and/or enjoy advantages like scale, brand strength or intellectual property which can help it see off any rivals.

Applying the ROCE to a real-world example

Refuse specialist Biffa (BIFF) reported a statutory operating profit of £74.1 million for the 12 months to 27 March 2020. In the same set of results, it reported total equity attributable to shareholders of £144 million and non-current liabilities came in at £627 million.

CALCULATE THE RETURN

Operating profit = £74.1 million

CALCULATE CAPITAL EMPLOYED

• Shareholders’ equity = £144 million

• Non-current liabilities = £627 million

• Shareholders’ equity + non-current liabilities = £771 million

PUT IT TOGETHER

£74.1 million/£771 million = 0.096 x 100 = 9.6%

ROCE = 9.6%

These figures add up to a ROCE of 9.6%. This level seems logical as dealing with rubbish is not likely to be area which generates premium returns. In this context Biffa’s ROCE is acceptable.

If we used the adjusted profit figure of £95 million instead, which strips out items like restructuring costs and write-offs linked to acquisitions, then the ROCE comes in at 12.3%.

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