Value Educator

Value Educator

25-10-2022

13:39

How to interpret Return on Capital Employed (ROCE)? A short thread with examples ! Like and retweet for better reach !

1. We all know that Return on Capital Employed (ROCE) is the measure of a company's operating profit divided by its capital employed. It basically tells us how efficiently a company generates its operating profit through the capital it has infused in the business.

2. But it's very important to understand different drivers of Return on capital employed (ROCE). Return on capital employed (ROCE) is driven by two factors-EBIT or operating margin and capital employed turnover. We’ll see this using some examples.

Case1: Deepak Nitrite If we check in the case of Deepak Nitrite, the EBIT margins have increased from 8% in 2015 to 22% in 2022 but the capital employed turnover ratio has been constant over the years.

So the ROCE has expanded from 8% in 2015 to 40% in 2022 due to expansion in margins. Margins have expanded due to various reasons such as cost competitive measures, change in product mix etc.

Case 2: Nestle India If we check in the case of Nestle India, the EBIT margins are fairly constant from 2018-2021 and in the range of 22-23%. But if we check its ROCE has expanded from 41% in 2018 to 60% in 2021.

So the major driver for ROCE expansion here is the capital employed turnover ratio which has increased from 1.81 in 2018 to 2.64 in 2021. Nestle India is a market leader in most of its products and enjoys high bargaining power with suppliers

and therefore its capital employed turnover ratio is high. Conclusion: So today's ROCE might be high but we should also check for its sustainability. If the EBIT margin in a business is high it would attract competition and eventually the EBIT margin will fall

which will in turn lead to reduction in ROCE. So we should look at businesses which have high barriers to entry so that even if competition comes it won’t impact its operating margin.

We should also check for the company’s capital allocation, if the allocation is good the company should be able to generate incremental revenues from through its capital employed.

So if the product of the company is unique and there is product differentiation the company will enjoy high capital employed turnover. So basically ROCE is in turn a function of entry barriers, capital allocation, product differentiation etc. Like & Retweet for better reach !



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