Writing these #InvestingBasics articles is quite refreshing, because this is like a test for me on how well I know my investing concepts. Takes me back to when I was a kid and had just started to learn about investing. This is like a re-vision for me. And you learn something new every time you re-visit a concept.
This week, we’re going to talk about one of the most important metrics to look out for while evaluating companies — return on capital employed [RoCE].
Why is it important? What does it tell you about how well a company is being run + the execution capabilities of the management?
We’ll uncover all of these, but first let’s understand what RoCE means.
What is RoCE?
If you want to start a business, you need money — lots of it. There are multiple ways of raising money to start a business. You could use your own money, that you’ve saved over the years. Or take a loan from a bank against your creditworthiness. Or raise money from external investors (VC, PE, angel investors) for a stake in your business.
Once you get the money, also known as ‘initial capital’ in business terms — you deploy it. You need to buy / rent an office. You need to buy machines. Office equipments. Furniture. Computers. You need to hire people. You need to buy raw materials to manufacture goods. Subscribe to AWS for your data requirements. There’s a lot of things you need to spend money on before you can start a business.
So your money gets deployed into various avenues to run your biz. Unless, you’re an NGO — one of your primary objectives would be to make profits.
You manufacture goods. Or maybe you are providing a service — that’s your operating revenue.
You spend money on raw materials. You spend money to pay salaries. You incur other expenses like legal costs, rent, maintenance, marketing, electricity, fuel etc. — that’s your operating expense.
Operating revenue — operating expense = Operating profit (also known as EBITDA)
As a business owner, you want to ensure that you make enough profits that you’re generating market beating returns. That’s where RoCE comes into play.
Formula for RoCE = EBITDA* / Capital Employed**
*EBITDA = Operating profits
**Capital Employed = Total Assets (minus) Current Liabilities
Why is RoCE important?
Because it tells you how good a business is.
As a business — if your RoCE is <6-7%, it doesn’t make sense to do that business because you could make the same returns putting your money in a fixed deposit or an index fund. Why go through the hassle of running a biz only to make a return of 6%?
I’ve taken construction companies in this example, because these are generally capital intensive businesses. You need to invest a lot of money upfront into building real estate and the business cycle is long. Sometimes the property doesn’t get built, and money gets blocked.
In a capital intensive industry, if a company is able to generate market beating returns (anything > 15% RoCE) — that is VERY impressive 🚀.
And, it is important to not look at a single year’s RoCE but the 5Y average RoCE as well to see if the company is consistently generating above average returns from it’s business.
In the example above, you can see that only 5 companies are able to generate >15% RoCE. Arkade & PSP Projects are clearly executing their projects in a stellar manner, posting 5Y Average RoCE of >25%.
Mahindra Life is clearly struggling. Macrotech & National Standard are barely beating FD returns. Elpro International & B.L. Kashyap are decent.
I’m adding Arkade to my watchlist, probably going to cover this stock in the future given the impressive RoCE! 😉
You can see a stark contrast here. IT sector, is asset light. It is dependent on hiring software engineers and they have a lot of freshers with entry level salaries — which helps them generate such kinds of RoCE.
A 19% RoCE in the IT sector wouldn’t be as impressive as a 19% RoCE in the construction sector. So, it’s important to keep in mind the sector a company operates in to build a baseline expectation of what you can expect in terms of RoCE.
What can you deduce from it?
A single ratio gives you a lot of information when making an investment decision.
Strength of the business model — if a business can generate >15% RoCE over long periods of time (without undertaking fraudulent activity ofcourse 😂) — it is a testament that their business model is very strong. It is probably operating in a sector that generate high RoCE. But, if it operating in a capital heavy sector and can still generate >15% RoCE — the company definitely has some kind of moat.
Capital allocation abilities of the management — the management is equipped with taking decisions to drive the company’s future growth. Which products to launch? How to stay ahead of competition? How to increase market share? How to increase profits? A consistently high RoCE gives a clear message — that the company’s management has the ability to make great decisions and have unparalleled business acumen.
Comparison with peers — when you’re doing a sector analysis and looking at several companies in the sector, companies with higher RoCE compared to peers tell you which company is being run more efficiently.
In the example above, you can see how TCS is knocking every company out of the park in terms of RoCE, and that’s a primary reason why it is one of the most valuable companies in the world.
Less growth in salaries — this is probably not going to make you happy if you’re an employee, but a company with a stellar RoCE is probably able to achieve such returns by not paying their employees exorbitant salaries & insane growth. That doesn’t mean it’s not a good company to work for — but it will not offer you 50% YoY growth in salaries that’s for sure!
So — the next time you’re looking at a company, study it’s RoCE. Look at the 5Y Average. Understand whether the sector is capital intensive or asset light. Look at peers, to get a fair comparison on how it’s competitors are doing. And from this ratio alone, you can deduce a lot of information that you won’t find in any annual report or earnings call.
Use it wisely, and you can screen a lot of great investments for your portfolio. 💪
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[Note: The author is not a SEBI registered investment advisor and the contents of this article do NOT constitute investment advice. Always do your own research before you invest in a company]
Nicely explained 👍
Bro can we consider EBIT instead of EBITDA in the ROCE formula, as Operating profit refers to EBIT?