Evaluating based on Return ratios
One must look at how efficient the company is in utilizing its Capital while generating profit.
That’s when Capital based return ratios come into play.
In this resource let us understand about Return on Capital employed (ROCE)
What is Return on Capital Employed?
A company may be earning good margins on its Sales. But, evaluating just based on such margins would not be appropriate. One must also look at the amount of capital that is deployed into the business through which the company is generating such returns.
Return on Capital employed or ROCE in short helps us in understanding if the company is making efficient use of its Capital.
It shows how much operating profit is the company making on each dollar of Capital that is deployed.
Let us look at how exact calculation of the ratio.
Formula for Return on Capital Employed
The formula of the Return on Capital employed is quite logical.
We take EBIT (Earnings before Interest and Taxes ) in the numerator.
Average Capital employed in the denominator
EBIT (Operating Profit)
EBIT (Earnings before Interest and Taxes) is also called as Operating Profits. It shows how much profit is the company making at an operational level.
It does not include any non operational Revenues or one time Revenue.
EBIT can be calculated from the Income Statement. The formula is shown below
EBIT = Revenue – Cost of Sales – Depreciation & Amortization – Other expense
Expenses like Interest and Taxes are not deducted from the Revenue
Capital employed is nothing but the overall money deployed into the business.
It includes both the Equity Capital given by Equity shareholders and Debt Capital given by various lenders or Debt investors.
Practically speaking, Capital Employed can be calculated in many ways.
But in this resource, we are sticking to the below-mentioned formula.
Capital Employed = Equity Capital + Debt Capital
- Both Equity Capital and Debt Capital can be taken from the Balance Sheet.
- Although calculating Equity Capital is relatively easier since it is outrightly reported on the Balance Sheet, arriving at total Debt Capital requires some decision making.
- Companies may have its Debt Capital reported under various heads (Current, Non-current).
- Only liabilities that are in the nature of Debt have to be considered.
Why specifically EBIT in the numerator?
If you observe, we take specifically EBIT in the numerator instead of Pre-tax profit or Net Profit. The logic is simple.
Tax authorities and Equity shareholders both have shares in Pre-tax profits. While only Equity shareholders have a share in Net profit.
Since we are taking Equity Capital and Debt Capital in the denominator, we need to take such a profit which is attributed to all capital providers. Hence, we take Operating Profit which belongs to both the Capital providers. Only then our calculations will make sense.
Let us calculate the ratio using an example given below.
How to calculate Return on Capital Employed – Example
As part of this example consider two companies Alpha Inc. and Beta Inc.
Assume both the companies are operating in the same industry.
Below given is the condensed Income Statement for both the companies. The values are in $ million
Further, consider the Balance Sheet extract for the companies.
To calculate return on Capital employed we need,
- Earnings before Interest and Taxes (EBIT)
- Capital employed
EBIT can be calculated from the Income Statement.
We reduce all the expenses except Interest cost and income Taxes.
Alpha Inc. is = $300 – $60 – $30 – $15 = $195
Beta Inc. = $300 – $75 – $60 – $15 = $150
Capital employed is = Total Debt + Total Equity
Alpha Inc. = $120 + $300 = $420
Beta Inc. = $10 + $100 = $110
The below chart quickly summarizes both the numerator and the denominator for both the companies.
As evident from the chart above Alpha Inc. as relatively higher Capital employed.
Let us calculate ROCE and evaluate which company is making best use of its Capital.
ROCE = EBIT / Capital Employed
Alpha Inc. = $195 / $600 = 33%
Beta Inc. = $150 / $300 = 50%
The above table quickly summarises the ROCE calculation for both the companies.
As evident from the calculation above Alpha Inc. has ROCE of 33% and Beta Inc. has 50%.
What does 33% and 50% ROCE mean?
It means on every $100 of Capital employed by Alpha Inc., it earns $33 as operating profit.
Similarly, on every $100 of Capital employed by Beta Inc., it earns $50 as operating profit.
Clearly, Beta Inc. earns a higher return on its Capital. Hence, it must be appropriate to conclude that Beta Inc. is utilizing its Capital better.
Return on Capital Employed using Excel – Walmart Inc case study.
In our next example, let us calculate the ROCE using excel for the year ending 31st January 2020.
You can download the template using the below option.
Once you download the template you will see the consolidated Income Statement of Walmart for the past 6 years.
Similarly the file also has the consolidated Balance Sheet.
To calculate return on Capital employed we need EBIT and Capital employed. Let us calculate numerator and denominator.
Earnings Before Interest and Taxes (EBIT)
To calculate EBIT, we reduce all expenses from the Revenue except Interest expense and Income Taxes.
EBIT = Revenue – Cost of sales – SG & admin expenses – Depreciation and amortization
EBIT = $523,964 – $394,605 -97,804 – $10,987 = $20,568
Company has long term Debt and short term Debt as part of its Debt Capital.
Capital employed = Short term Debt + Long-term Debt + Equity Capital
= $575 + $43,714 + $8,152 = $125,841
Below table is an extract showing the the Capital employed for the company
Now that we have both the values, let us calculate the ratio using Excel.
Return on Capital employed is = EBIT / Capital employed
= ($205 68 / $125,841 ) * 100 = 16.3%
What does ROCE of 16.3% indicate?
It indicates that for every $100 of Capital employed by the company, it generates $16.3 of operating profit.
Since $16.3 is an operational profit, various expenses like Interest cost, Income Taxes, etc has to be further reduced from this amount.
Although at a high level 16.3% may appear good if the company has significant Debt on its Balance Sheet most of its profits are eaten away by Interest expense. After deducting Income Taxes as well, the company may earn a nominal return to Equity shareholders.
Whether this 16.3% ROCE is good or bad has to be decided only after looking at ROCEs of other competitors in the same sector.
How to Interpret Return on Capital Employed?
As already discussed the ROCE helps in understanding the company’s ability to generate returns on its Capital.
If ROCE is high, it invariably means that the company earns higher operating profit on each dollar of capital employed. This indicates better utilization of the Capital.
High ROCE would mean more profits for the company. Such profits can be redeployed into the business. This leads to the growth of the company.
Higher ROCE means the management is efficient in deploying the Capital in projects that have a good return profile.
Low ROCE would mean that the company is deploying its Capital in projects that are not profitable.
Low ROCE may be a result of Management’s improper planning and execution. At times, the company may evaluate projects with insufficient information leading to lower than expected returns
If the company is persistently earning low ROCE, this may result in continuous wealth destruction. If appropriate measures are not taken on time, in the end not much would be left for the shareholders.
ROCE and weighted average cost of Capital (WACC)
Another application of ROCE has to do with company’s Weighted Average Cost of Capital(WACC).
Company’s ROCE is generally compared with its Weighted Cost of Capital (WACC) to determine if any value is created for its shareholders.
If company’s ROCE > WACC, value is created
On the contrary, if the ROCE<WACC, wealth is destroyed.
Apart from ROCE, even other Capital-based return ratios are used to compare with WACC to determine a company’s performance.
Return on Capital Employed Case Study 1: Home Depot
In the case study below, we will examine the ROCE profile of a US-based home improvement company Home Depot.
As evident from the chart above, the company’s ROCE has been increasing since 2015.
If we recall the formula,
Return on Capital Employed = EBIT / Capital Employed
ROCE of any company will increase under the below mentioned circumstances.
- EBIT is increasing at a much faster rate than the Capital base.
- Capital Employed is decreasing at a much faster rate than EBIT
In the above given case of Home Depot, the second point is relevant.
Over the past few years, the company has performed a series of buybacks resulting in reduced Equity base.
There has been a moderate increase in Debt Capital and a significant reduction in Equity Capital. This has lead to a reduction in overall Capital employed for the company.
Hence, the company’s ROCE has been increasing over the past few years.
In the next few sections, let us understand how various companies in different industries generate returns on their Capital.
We have already calculated the ROCE for Walmart as part of the example above.
We observed that the company does not generate significantly high returns on its Capital. Nonetheless the company makes decent ROCE in the range of 16%-18%.
Although the return ratios are not volatile, the company is unable to improve them.
For the year ending 2019, the Return on Capital Employed for Walmart is 15.2% which is 11% lower from the previous year.
Another US-based company Amazon Inc. makes around $15 as operating profit on every $100 of Capital deployed into the business.
Although this is not as great as Walmart or Home Depot, the company is able to increase the ROCE over period.
Barring the period of 2015-2017, company’s ROCE profile is currently stable.
For the year ending 2019, Amazon had a return on Capital employed of 15% which is similar to what it earned in 2018.
Home Depot Inc
As per the case study above, we observed how Home Depot was able to increase its ROCE for the past 5 years.
The company, with a series of buy-back programs, strategically reduced its Equity base resulting in increasing ROCE.
For the year ending 2019 on every $100 of Capital employed the company was able to earn $57.
This indicates in almost less than two years the company would recover its Capital employed. All subsequent returns would be pure profits for the shareholders.
Clearly, among all the four Tech companies under the discussion, Apple has a relatively higher ROCE.
Every year the company comfortably generates more than $25 Operating Profit on every $100 of Capital employed.
There was a fall in its return ratio a few years back, but, now the company appears to be back on track.
Even though the company is unable to increase the ratio further, at such a huge Balance Sheet, even rewarding its shareholders with steady ROCE would be considered an achievement.
Similar to Facebook, even Microsoft was able to increase its ROCE for the past few years.
The ratio, back in 2015 was at around 15%. Subsequently, due to a better sales mix and pricing power, the company was able to earn higher operating profit margins resulting in increased operating profits.
Currently, for the year ending June 2019, the company has a ROCE of around 28% which is at its peak.
Among all the tech companies as part of our study, clearly Google has a relatively stable return profile.
The company, over the past few years has been earning ROCE in the range of 17%-19%
For the year ending 2019, on every $100 invested into the business as Capital, the company was able to fetch $18 as operating profit to its Capital providers.
Given the huge growth potential in the technology space, the company is expected to reap results in the form of higher profits in coming days.
Johnson & Johnson
Moving away from retail and technology space, let us look at how pharmaceutical companies generates return to its Capital providers.
Johnson & Johnson is a US-based pharma and medical equipment manufacturer having a global presence.
As evident from the chart above, the company comfortably makes ROCE of more than 20% every year.
For the year ending 2019, the company was able to earn $20 on every $100 deployed into the business as Capital.
With ongoing COVID pandemic and global demand for the company’s drugs, J&J is expected to perform well in the coming days.
With an increasing shift towards online payment, Global payment platform company PayPal has a clear path of growth in coming future.
The company had a ROCE of 11% in 2015. Subsequently, due to better cost control and pricing power, the company was able to generate a higher return on its Capital.
Over the past 5 years, the company increased its return ratio from 11% to 14%.
The ROCE profile for US-based oil company ExxonMobil is quite volatile.
Back in 2015, the company was earning $6 on every $100 of Capital invested. Suddenly, in 2016, the company could not earn any return for its Capital providers.
Since 2017, the ratio has turned positive and is gradually improving. As the company is highly exposed to global oil price risk, such a great volatility in its performance is not unusual.
For the year ending 2019, ExxonMobil had a ROCE of 12% which is 35% more than that of 2018.
This concludes the detailed explanation of ROCE.
As seen in the previous section, various companies have different return ratios depending upon Industry dynamics. Comparing companies from two different industries would lead to the wrong conclusion. Hence, a detailed understanding of industry characteristics is a must before analyzing the companies within them.
Below are other important recommended resources related to the topic.