Fundamental stock analysis uses a variety of key figures: Sales growth, earnings per share, net debt, P/E ratio, P/E ratio, free cash flow, etc. The number of key figures that can be derived from a balance sheet is huge.
I would now like to take a closer look at what I consider to be an underestimated key figure: ROCE. ROCE" stands for return on capital employed. Roughly speaking, ROCE measures how efficiently and profitably the capital employed is being used. ROCE is often not stated, at least in German-speaking countries, which I personally think is a great pity. Of course, you can calculate ROCE yourself using the company's balance sheet. ROCE is defined as follows:
ROCE = EBIT / (capital employed).
EBIT (earnings before interest and taxes) is the operating profit and the capital employed describes in simple terms how much capital was used to achieve this profit. There are many different definitions of what is regarded as capital employed, but the following are common (according to [2])
capital employed = total assets - current liabilities.
Total assets refers to the assets of the company (from the balance sheet) and the current liabilities are the company's current liabilities. It is important that the key figures EBIT, total assets and current liabilities are all considered in the same period: quarterly, annually or annually. There is therefore no point in offsetting the EBIT of the financial year against the capital employed of the last quarter.
However, this is not intended to drift into an article about various accounting ratios (sorry @TheAccountant89), but merely to give you a feel for what is meant by ROCE.
1. interpretation of ROCE
ROCE measures the efficiency of the capital employed. To put it simply, the higher the ROCE, the better. ROCE is usually expressed as a percentage. A ROCE of 0.3, i.e. 30%, is interpreted to mean that 30% of the capital employed to generate operating profit is ultimately reflected in the balance sheet as operating profit. This means that for every $100 of capital employed, there is ultimately an operating profit of $30 on the balance sheet. If the ROCE is now increased to 40%, $40 remains from $100 of capital employed and it is now clear why the ROCE serves as a measure of a company's efficiency.
Is this now the holy grail for evaluating a company? Of course not. The limitations of ROCE can be recognized simply by the fact that only 3 key figures from a company's balance sheet are initially used in the calculation. The following, for example, are completely disregarded: sales growth, profit growth, long-term liabilities, etc. Nevertheless, there are some valid arguments in favor of ROCE for including it in the valuation of a company:
1.) Comparing ROCE can make sense for companies from the same/similar sector. Example: Comparison of the ROCE of Microsoft and Adobe.
2) Observing the development of ROCE over time to discover any increases or decreases in efficiency. For example: Development of the ROCE of Home Depot over the last 10 years.
3) Finding profitable business models in general. For example: ROCE Volkswagen approx. 6%, Adobe approx. 30%.
However, you should always keep an eye on what exactly is being compared and always remember that ROCE cannot be used as the sole measure of a business model's profitability. As with almost all key figures, ROCE only reveals its full power when it is combined with other meaningful key figures and viewed over a longer period of time.
2. combination with other key figures
Combination with sales growth
A high and constant/stable ROCE over time together with good sales growth reflect constant efficiency with increasing sales. As a result, the company grows with the same efficiency; profits increase in absolute terms.
A poor development of the company could be indicated, for example, by rising sales and simultaneously falling ROCE. The company then grows in sales (possibly also in operating profit) but at the expense of capital efficiency. This could lead to problems if sales growth declines in the future.
Combination with long-term liabilities
The calculation of ROCE only includes current liabilities (current liabilities) of the company are included. The respective accounting period is to be regarded as short-term. For example, if we calculate ROCE on the basis of the financial year, only those liabilities of the company that were payable within the same financial year are included in the calculation. Debt payments to be made in the coming years are not taken into account. It is therefore always advisable to pay attention to the company's net debt. Low debt and a high ROCE is the desired combination here.
Combination with free cash flow
As only EBIT is included in the calculation of ROCE, accounting standards allow for some legal trickery and financial engineering in the process. Companies often report profits but still have a negative free cash flow. The ideal combination is therefore a high ROCE with a rising positive free cash flow.
3 All theory is gray: two examples
As already mentioned in the introduction, ROCE is rarely stated. Therefore, sometimes there is no choice but to do the math yourself. An example of how you can calculate ROCE yourself using a company's balance sheet can be found in [3] under the section "Nestle Return on Capital Employed".
We will now proceed in such a way that two example companies from the same sector are presented. I will not reveal which companies so that you can look at the figures objectively. All figures come from [4]:
Stock A (all figures in USD million): 2017 | 2018 | 2019 | 2020 | 2021
Turnover: 141.576 | 152.703 | 166.761 | 195.929 | 226.954
Operating profit (EBIT): 4.480 | 4.737 | 5.435 | 7.223 | 7.793
Total current liabilities: 19.926 | 23.237 | 24.844 | 29.441 | 31.998
Total liabilities and equity (total assets): 40.830 | 45.400 | 55.556 | 59.268 | 64.166
Total liabilities: 27.727 | 29.816 | 36.851 | 41.190 | 43.519
Stock B (all values in USD million): 2017 | 2018 | 2019 | 2020 | 2021
Turnover: 123.280 | 121.852 | 122.286 | 132.498| 137.888
Operating profit (EBIT): 2.450 | 2.677 | 2.672 | 3.179 | 3.709
Total current liabilities: 14.197 | 14.274 | 14.243 | 15.366 | 16.323
Total liabilities and equity (total assets): 37.197 | 38.118 | 45.256 | 48.662 | 49.086
Total liabilities: 30.292 | 30.283 | 36.683 | 39.112 | 39.657
Please don't be overwhelmed by all the numbers. Take a look at the figures. How are the figures developing? Which company do you find more attractive based on the figures alone and why?
We will now use these figures to calculate ROCE, sales growth, EBIT growth, the EBIT margin and the ratio of debt to sales (total liabilities / sales). As defined above:
ROCE = EBIT / (total assets - total current liabilities).
A brief example calculationTo calculate the ROCE of Stock A in 2017, we calculate 4,480 / (40,830 - 19,926) = 0.214 = 21.4%. The remaining calculations can be done in a spreadsheet of our choice, for example. The result then looks like this:
Stock A: 2017 | 2018 | 2019 | 2020 | 2021 | Average*
ROCE21.4% | 21.4% | 17.7% | 24.2% | 24.2% | MW: 21.8%
Sales growth: -- | 7.9% | 9.2% | 17.5% | 15.8% | MW: 9.9%*
EBIT growth: -- | 5.7% | 14.7% | 32.9% | 7.9% | MW: 11.7%*
EBIT margin3.2% | 3.1% | 3.3% | 3.7% | 3.4% | MW: 3.3%
Debt/turnover19.6% | 19.5% | 22.1% | 21.0% | 19.2% | MW: 20.5%
Stock B: 2017 | 2018 | 2019 | 2020 | 2021| Average*
ROCE: 10.7% | 11.2% | 8.6% | 9.5% | 11.3% | MW: 10.3%
Sales growth: -- | -1.2% | 0.4% | 8.4% | 4.1% | MW: 2.8%*
EBIT growth: -- | 9.3% | -0.2% | 19.0% | 16.7% | MW: 10.9%*
EBIT margin2.0% | 2.2% | 2.2% | 2.4% | 2.7% | MW: 2.3%
Debt/turnover24.6% | 24.9% | 30.0% | 29.5% | 28.8% | MW: 27.5%
Let the result sink in. Which company would you only prefer based on these figures alone? (*=mean values in this case CAGR)
A's ROCE has averaged 21.8% over the last 5 years and is very stable apart from the outlier in 2019. The ROCE of B averages 10.3% but fluctuates somewhat more strongly around the mean value. The first observation is that A is more efficient than B in terms of ROCE. This means that for every $100 of captial employed, A leaves about $21.80 in profit, while B leaves only $10.30. Both companies also operate in the same sector, so the ROCE should be comparable. The higher efficiency of A is a nice observation, but without the other ratios it doesn't mean that much.
A is also ahead in terms of sales growth. The strong boost in 2020 and 2021 with a simultaneous increase in ROCE indicates a functioning business model, as sales are rising and capital efficiency is improving. At B, sales grew primarily in 2020 and 2021 and stagnated in the remaining years. ROCE has also grown in these years.
For both companies, EBIT has risen by an average of around 11% over the past few years. However, B had a year with negative EBIT growth in 2018. The EBIT margin is comparatively low for both companies, but A is slightly ahead here too. A look at the debt ratio also shows that A has a very stable debt ratio of around 20% over the years. At B, the debt ratio increased by around 5% to 30% in 2019 and has since been reduced somewhat.
In the overall assessment, I would clearly opt for company A. The higher and, above all, more stable ROCE, coupled with good sales growth, the higher EBIT margin and the lower debt ratio, leaves me with no other option. In this case, the ROCE serves as an indicator for me that the business model of A is significantly more efficient than B, even if the EBIT margins may not differ so significantly.
Can you guess which companies we are talking about? Feel free to share your tips in the comments.
Sources:
[1] Value-oriented management of companies and groups using key figures: https://www.uibk.ac.at/psychologie/mitarbeiter/leidlmair/haeseler_hoermann_3.indd.pdf
[2] Wikipedia: https://en.wikipedia.org/wiki/Return_on_capital_employed
[3] Wallstreetmojo: https://www.wallstreetmojo.com/return-on-capital-employed-roce/#h-roce-formula
[4] Seeking Alpha: https://seekingalpha.com/
