Return On Capital Employed (ROCE)

The ROCE is calculated by expressing the operating profit before tax as a percentage of the year-end capital employed.

The main features of ROCE as an investment measure are as follows:-

1. High ROCE (in the region of 20% or more) is a validation of a company's competitive advantage. It indicates that the company has something special to offer - products or services that command a high return. It usually follows that margins are above average. The trend of both capital employed and margins is, therefore, of considerable importance.
2. Comparison of the ROCE of a company with others in its sector is a far more pertinent measure than comparison with the market as a whole. Companies with low returns are always suspect because they are in danger of becoming loss-making if trading conditions deteriorate. Companies with exceptionally high returns may invite competition for their products or services, unless they are fully protected by patents or in some other way.
3. The ROCE of a company should always be compared with the current cost of borrowing. If the ROCE is significantly higher, further borrowing adds to EPS; if the ROCE is lower, further borrowing will reduce EPS.
4. Companies with low ROCE are often the subject of changes in management control which, in turn, are frequently followed by a rights issue. The most acid test of new management is whether or not it is able to lift the return on capital employed.
5. The obvious attraction of a high ROCE is that a greater than average amount of profit can be ploughed back into the business for the advantage of shareholders. The plough-back is then employed again at the higher than average rate and helps to generate further growth in EPS. For this reason, a high ROCE is usually a common denominator of great growth stocks.

ROCE has not been calculated for banks and insurance companies. The ROCE of most property companies and of some financial companies should be viewed with caution, as the statistic may not be particularly meaningful.

Capital employed is the sum of ordinary and preference share capital plus reserves, debentures, loan stocks, all borrowings including obligations under finance leases, bank overdraft, minority interests and provisions. Deductions include investments in associated companies. The basic idea is to arrive at a final figure that will tell you how much money (whatever the source) is being employed in the operation of a business. The resultant figure is then compared with the operating profits before tax, exceptional items, interest, dividends payable and share of profits or losses of associated companies. The percentage this figure bears to adjusted capital employed gives investors a measure of the return the business can
produce on the capital employed within it.

A significant problem arises with goodwill, brand names, patents, copyrights, newspaper titles and the like. There is no doubt that intangible assets can be immensely valuable, but the accounting treatment of them can vary considerably. For example, brand names sometimes have no value in the balance sheet and, at other times, they are written up in value to a significant proportion of the net assets. The difficulty is that no fair value can really be established unless a competitive auction tests the market. Any valuation made by the board is essentially arbitrary and, therefore, subjective.

In REFS all intangibles are excluded. This treatment has the following advantages:-

1. It is consistent.
2. It measures the operating efficiency of a business by comparing operating profits with operating assets.
3. It does not change the operating efficiency of a business being acquired. For example, an acquiring company may pay double tangible asset value for a business. If the resultant goodwill were left in the balance sheet, this would halve the ROCE of the business in the accounts of the acquiring company. In fact, the operating efficiency of
   the business acquired would remain unchanged and this is reflected in the REFS figures which exclude goodwill.