Download Return on Capital Employed The ROCE Formula Calculating ROCE

This column covers fundamental analysis, which involves examining a company’s financial
statements and evaluating its operations. The analysis concentrates only on variables directly related
to the company itself, rather than the stock’s price movement or the overall state of the market.
Return on
Capital
Employed
In the First Quarter 2010 installment of Fundamental Focus, we
discussed two of the more popular
measures investors use to gauge the
relative profitability of a company—
return on assets (ROA) and return
on equity (ROE). Both represent
management’s ability to generate
profits; however, both give an incomplete picture of the capital base that
management has at its disposal, since
they consider only total assets (in the
case of ROA) or total equity (in the
case of ROE). Anyone who has taken
a basic accounting course knows that
the capital structure of a company is
composed of assets, owners’ equity
and liabilities. A third measure—return on capital, or return on capital
employed (ROCE)—adds a company’s debt liabilities to the equation
to reflect a company’s total “capital
employed.”
Return on capital is used by Joel
Greenblatt to identify good businesses in his popular book “The Little
Book That Beats the Market” (John
Wiley & Sons, 2006) and its followup, “The Little Book That Still Beats
the Market” (John Wiley & Sons,
2010). Return on capital measures
the operating profit of the tangible
investment (capital) that company
management uses to generate that
profit. In other words, return on capital measures how much profit a company earns on every dollar invested
in inventory and property, plant and
equipment. The higher the return on
capital, the greater the company’s
ability to expand in order in grow
earnings. Likewise, high profitability and earnings growth should, in
theory, attract investors who, in turn,
will bid up the share price.
The ROCE Formula
As we mentioned earlier, many
investors use return on equity (net
income divided by shareholders’ eq20
uity) or return on assets (net income
divided by total assets) to judge the
profitability of a business. By comparison, return on capital employed,
as defined by Greenblatt and others,
is calculated as follows:
ROCE = EBIT ÷ tangible capital employed
Where,
EBIT = earnings before interest and taxes, and
Tangible capital employed = adjusted net
working capital + net fixed assets.
This definition of return on capital
uses the pretax operating earnings
of a company instead of net income,
which is used in the ROA and ROE
calculations. By using EBIT (earnings
before interest and taxes), we ignore
debt levels and tax rates, which will
differ from company to company. Instead, we focus on profitability from
operations relative to the cost of the
assets used to produce those profits.
Looking at the denominator of the
return on capital calculation, tangible
capital employed is used instead of
total assets (used to calculate ROA)
or equity (used to calculate ROE) to
better capture the actual operating
capital used by the business. ROE,
by focusing on equity, ignores assets
financed via debt, while the total
assets figure used in calculating ROA
includes intangible assets and other
assets that may not be tied to the primary operation of the firm or assets
that are financed by suppliers.
Tangible capital employed is the
sum of adjusted net working capital
and net fixed assets. Net working
capital is typically defined as current assets less current liabilities.
However, we take this one step
further by narrowing our focus to
accounts receivable, inventory and
cash needed to conduct business less
accounts payable. A company must
fund its receivables and inventory,
but does not have to pay money on
its payables as long as they are paid
off within the terms of their specific
agreement. In effect, therefore, payables are an interest-free loan. Cash
and short-term investments are also
(usually) excluded, since they are not
used to run the current operations
of the company. To include cash that
may not yet be employed would be
to overstate a company’s capital and
reduce its return on capital. Again,
the focus of return on capital is on
the actual capital the company has
invested in its business. Lastly, net
fixed assets are defined as property,
plant and equipment less accumulated depreciation.
Calculating ROCE
Table 1 shows the calculation of
return on capital for retailers Target
Corporation (TGT) and Wal-Mart
Stores, Inc. (WMT), along with the
relevant financial statement data. The
financial data used for Wal-Mart is as
of October 31, 2011, and for Target
the data is as of October 29, 2011.
We used AAII’s fundamental stock
screening and research database program Stock Investor Pro as the source
for the numbers. However, the data
is easily found in SEC filings and on
financial websites such as Yahoo!
Finance and SmartMoney.com.
Earnings before interest and taxes,
the numerator of the ROCE formula, is simply the sum of operating income over the last 12 months
(trailing four quarters). The adjusted
net working capital figure used in the
denominator ignores cash and shortterm investments on the current
assets side of working capital because
they are not used in current operations of the firm and are assumed to
not yet represent operating assets.
However, some analysts include cash
and short-term investments if excluding them results in a negative net
working capital position.
Interpreting ROCE
From our calculations at the bottom of Table 1, we see that Wal-Mart
has a return on capital employed
of 21.5% versus 14.8% for Target.
Computerized Investing
Table 1. Return on Capital Employed Calculations
Target Corp. (TGT)
Wal-Mart Stores, Inc. (WMT)
As of 10/29/2011
As of 10/31/2011
Quarterly Balance Sheet
(Millions)
Assets
Cash & Equivalents
Short-Term Investments
Accounts Receivable, Net
Total Inventory
Other Current Assets
Total Current Assets
Net Property, Plant & Equipment
Liabilities
Accounts Payable
Short-Term Debt
Other Current Liabilities
Total Current Liabilities
$755.0
$66.0
$5,713.0
$9,890.0
$1,948.0
$18,372.0
$29,040.0
$7,063.0
$0.0
$4,757.0
$44,135.0
$3,316.0
$59,271.0
$110,392.0
$8,053.0
$2,813.0
$3,273.0
$14,139.0
$37,350.0
$11,385.0
$18,604.0
$67,339.0
Income Statement
(Millions)
Sales
Cost of Goods Sold
Gross Income
Total Operating Expenses
Operating Income (EBIT)
12 Months Ending 10/29/2011
$69,238.0
$47,783.0
$21,455.0
$64,603.0
$5,399.0
12 Months Ending 10/31/2011
$440,141.0
$329,696.0
$110,445.0
$413,980.0
$26,161.0
ROCE Calculation
“Adjusted” net working capital
= Accounts receivable + inventory + cash for business – accounts payable
= $5,713.0 Mil + $9,890.0 Mil + $0.0 Mil – $8,053.0 Mil
= $4,757.0 Mil + $44,135.0 Mil + $0.0 Mil – $37,350.0 Mil
= $7,550.0 Mil
= $11,542.0 Mil
Tangible capital employed
= “Adjusted” net working capital + net fixed assets
= $7,550.0 Mil + $29,040.0 Mil
= $36,590.0 Mil
Return on capital employed
= $11,542.0 Mil + $110,392.0 Mil
= $121,934.0 Mil
= Earnings before interest and taxes ÷ tangible capital employed
= $5,399.0 Mil ÷ $36,590.0 Mil
= $26,161.0 Mil ÷ $121,934.0 Mil
= 14.8%
= 21.5%
Based on these figures, Wal-Mart
appears to be making better use of its
capital relative to Target. A high(er)
ROCE can indicate that a company
can reinvest a greater portion of its
profits back into its operations, to the
benefit of shareholders. The reinvested capital is, in turn, employed at
a higher rate of return, which helps
generate higher earnings growth.
When comparing financial measures such as return on capital, it is a
Second Quarter 2012
good idea to compare firms in similar
lines of business, which is one of the
reasons why we chose Target and
Wal-Mart for our example. While we
see that Wal-Mart’s ROCE is higher
than that of Target, there isn’t a lot
to be gained from using data from a
single point in time. Financial analysis yields the greatest insights when
analyzing trends over time. Companies that are able to generate higher
returns on capital year after year are
apt to have higher market valuations
relative to companies that consume
capital in order to generate profits. A
declining ROCE may point to a loss
of competitive advantage.
ROCE is especially useful for evaluating capital-intensive firms, or those
that require large amounts of initial
capital investment before they can
begin producing products. Examples
of these firms include utilities and oil
and gas companies.
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