Hello Readers! In today’ post, we will be exploring the formula and the concept behind the Return on Capital Employed or ROCE.
The topics we shall cover in the post are as follows,
- Formula and calculation
- How to calculate NOPAT?
- How to calculate Capital Employed?
- The conceptual and interpretation of the formula and closing thought
1. Formula and calculation
Return on Capital Employed, as the name states, is the profit generated by the total capital used by the company for its operations for a period. It is widely used as a measure of profitability in the financial and the investment community. Although not commonly used around three decades ago, it has traveled a long way to even occupy center stage in the decision making of some portfolio managers and retail investors.
ROCE is computed as the percentage of Net Operating Profit after Taxes (NOPAT) upon the total long-term capital employed.
Return on Capital Employed = NOPAT / Total Capital Employed
Since the NOPAT is generated over the financial period which the Capital Employed is a balance sheet item and is normally represented at a period in time, some investors argue that the use of ROCE based on average Capital Employed during a period is a better metric.
The calculation for that is as given below
Return on Capital Employed = NOPAT / Average Capital Employed
Where, Average Capital Employed = (Opening Capital Employed + Ending Capital Employed)/2
The denominator of the above expressions implies that ROCE can also be defined as the return earned by the business as a whole or alternatively as the return generated by the capital contributed by both the creditors and the equity holders of the firm together.
In the case where the debt-financed component of capital is very low, the ROCE should give a value closer to ROE for similar earnings than a company which operates with a highly leveraged position.
2. How to calculate NOPAT?
The NOPAT or the Net Operating Profit After Taxes are calculated on the basis of two key inputs, EBIT and the TAX rate. In India, we have a corporate tax rate of approximately 30% for companies with revenues greater than ₹250Cr and around 20% for companies with revenues less than ₹250Cr.
The NOPAT calculation is pretty straightforward and can be done as per the equation below,
NOPAT = Earnings Before Interests and Taxes (1-Corporate Tax Rate)
NOPAT = (Profit before Taxes + interest payments + one time adjustments) (1-Corporate Tax Rate)
The black box here in this equation is the one-time adjustments, this includes earnings and expenses which are not regularly generated through operating activities of the company. These may include litigation expenses, loss/gains from the sale of assets, gain/loss due to asset revaluation of inventory, etc.
(However, if a company makes these kinds of expenses or gain regularly, it would require deeper inquiry on the side of the investor)
3. How to calculate Capital Employed?
The calculation of the denominator part of the equation is fairly simple and can be done from the line items reported on the balance sheet of a company.
Since the Capital Employed as mentioned before refers to the total capital raised from both the debt holders of the firm and also the equity holders, the formula should reflect contributions of both the capital provides to the assets of the company.
Capital Employed = Total assets – Total current liabilities.
This could also be shown as,
Capital Employed = Shareholders Equity + Non-current liabilities
- How to read financial statements of a company?
- What is Working Capital? Definition, Importance & More.
- How To Evaluate The Cash Of A Business?
4. The conceptual and interpretation of the formula
Most investors in the financial world like to see that the company they are about to invest in has a ROCE value greater than the Weighted Average Cost of Capital or WACC. WACC best defined as the minimum return a company should get subject to its unique capital structure.
If the ROCE of a company is greater than the WACC then the company is said to generating value for its shareholders and it is advised that the shareholders continue to hold the company in their portfolio. If the company’s ROCE is less than WACC then it is said to be destroying shareholder value and since equity holders are the last paid in the preference order of payments it is advised that equity holders stay out of such a company.
The calculation of WACC or the minimum return to be achieved the company is slightly complicated however a non-finance retail investor who could instead compare ROCE by arriving at his own required rate of return.
Since most retail investors may not be familiar with the computation and the vagaries of WACC, we feel it would be beneficial to use the following thumb rule to come up with your own required rate of return.
Required Rate of Return (%) = (Risk free bond rate + inflation rate + market risk premium) margin of safety
Where the market risk premium refers to the additional premium an investor would expect for investing in markets for most cases it would be better to take a value between 3%-5%.
Assuming an interest rate on a 10-year Indian Government bond is 8.2 percent, inflation rate of around 8 percent, a market risk premium of 3% and a margin of safety of 20 percent,
Required Rate of Return (%) = (8.1+8 +3) 1.20= 19.1 * 1.20 = 22.9%
Now if a company generates a ROCE greater than 22.9% then the company is creating value at a rate greater than the rate of return we calculated above and could be a target for shortlisting for investments.
Although not entirely foolproof, ROCE provides a lot of insight into the working business model of a company. Furthermore, an investor could gain better insights if he/she were to compare the evolution of the ROCE value for the last 5 to 6 years of company to form an opinion.