RETURN ON CAPITAL EMPLOYED

RETURN ON CAPITAL EMPLOYED

Capital employed is just in simple term, the money invested.  

Return on capital employed is the company's return on the money it has invested.

ROCE = normalised EBIT / CAPITAL EMPLOYED X 100%

How to calculate the money invested in the company

1.  Calculated from the Asset side of the Balance Sheet

Capital employed = Total assets - Current Liabilities + Short term borrowings

2.  Calculated from the Liability side of the Balance Sheet

CE = TE + NCL + Short-Term Debt

CE = TE + Other NCL + Total Borrowings

Using average capital employed

ROCE is usually calculated using a company's average capital employed over a period of two years.

Ideally, you would like to know the amount of money a company has invested throughout the year, rather than at a frozen point in time when the financial statements were compiled.

The ROCE, ROA and ROE of Petronas Chemical Group in 2016

Petronas Chemical Group 2016


Balance Sheet

                            2016            2015            Average
CA                      11.5b            12.6b
CL                       21.3b           19.2b
TA                       32.8b           31.8b              32.3b


CL                        2.5b            3.1b
LTL                      2.0b            2.1b
TL                        4.5b            5.2b

TEq                     28.3b           26.6b              27.5b

TEq + TL            32.8b           31.8b



Borrowings         2016             2015  
Short term          0.069b          0.074b
Long term          0.137b          0.183b


What is the average Capital employed of Petronas Chemical in 2016?

Capital employed = TEq + LTL + Short Term borrowings

Capital employed in 2016  =  28.3b + 2.0b + 0.069b = 30.369b
Capital employed in 2015  =  26.6b + 2.1b + 0.074b =  28.774b

Average Capital employed = (30.369b + 28.774b)/2  =  29.6b





Income Statement

                             2016

Revenue              13.9b
EBIT                     4.2b
PBT                      4.1b
PAT                       2.9b



What is the ROCE of Petronas Chemical in 2016?

Return on average Capital Employed (ROCE)
= EBIT / average Capital Employed
= 4.2b/29.6b
= 14.2%

What is the Return on Average Asset of Petronas Chemical in 2016?

ROA
= PAT / Average Total Asset
= 2.9b / 33.2b
= 8.7%

What is the Return on Average Equity of Petronas Chemical in 2016?

ROE
= PAT / Average Total Equity
=  2.9b / 27.5b
= 10.5%


What is the EBIT profit margin of Petronas Chemical in 2016?

EBIT profit margin
= EBIT / Revenue
=  4.2b / 13.9b
=  30.2%


What is the Capital Turnover (Revenue Turnover on its Capital Employed) of Petronas Chemical in 2016?

Capital Turnover
= Revenue / Average Capital Employed
= 13.9b / 29.6b
= 47%



DuPont Formula

ROCE = EBIT profit margin x Capital Turnover

Understanding how a company makes its profits. How a company generates its ROCE?

DuPont analysis

Return on Capital Employed or ROCE
= EBIT / Capital Employed
= (EBIT/Sales) x (Sales/Capital Employed)


ROCE is determined by two elements:

1.  What is happening with profit margins.
2.  Sales generated per $1 of money invested (capital turnover)


1.  Profit Margins

Profit margins are determined by many different factors.

The key influences on profit margins are:

Prices

• Higher prices can boost margins.

Costs

• Particularly important is the split between fixed costs (cost that have to be paid regardless of the level of sales, such as rent and most wages) and variable costs (costs which vary with sales, such as raw materials).  
• Companies with a high proportion of fixed costs can see their margins change rapidly in response to small changes in turnover via a process known as operational gearing.

Mix of products

• Some sales are more profitable than others.
• A car dealer will make little profit on selling a new car but will make lots of profit on selling services and spare parts.
• A company can sell more sophisticated products at a higher price for its most profitable sales.

Volume sold

• Selling more products can boost margins where the company has a high proportion of fixed costs (i.e high operational gearing).
• This process can also work in reverse and is clearly seen in manufacturing companies.
• For example, an industrial plant will have costs related to buildings and machinery, energy, raw materials and wages.  
• Most of these costs are fixed and the company needs to sell a large amount of goods to cover them and break even.
• Once past break even, the fixed costs are spread over a larger amount of sales, which allows profits to increase rapidly.
• However, a sharp fall in sales pushes the company back towards break even and possibly into a loss if income cannot cover all the fixed costs.

By analysing these factors allows us to understand the business behind the profit margin numbers.

Profit margins which fluctuate over a period of time are a tell-tale indicator of a cyclical business (where sales move up and down in line with the general economy) and possibly one with high operational gearing.

• These businesses are more risky and their shares do not make suitable LONG TERM investments.
• Stable profit margins are a desirable characteristic of a business for long term investments.

Please spend time reading a company's annual report to see if it has anything to say about profit margins.

• Pay particular attention to any mention of changes in prices, sales mix and volume changes.
• High-quality companies grow by selling more (volume) and not just by charging more.
• A company which increases prices but does not increase sales is showing that its customers are responding to the price rise by buying less from them.
• This maybe a sign of trouble ahead and may lead to stagnating or lower profits in the future.

2.  Capital turnover

Capital turnover looks at how effectively a company is spending its money to produce sales.

A company can increase capital turnover by adopting some of these measures:


Boosting sales

• For example, increasing sales with new products.

Reducing money invested.

• Cutting working capital by holding less stock of finished goods, getting customers to pay their bills faster and paying suppliers later.
• Cutting the amount of money invested in new assets (capital expenditure, or capex), reducing spending on new assets or increasing efficiency by getting more sales for less investment.
• Getting rid of under-performing assets that have low capital turnover and low ROCE.

Additional notes:

How do you work out the capital employed or the amount of money a company has invested?

Capital employed 
= Total Asset - non-interest bearing Current Liabilities

Using the Asset side of the Balance Sheet:

#Capital employed 
= Total asset - Current Liabilities + Short-term borrowings


Using the Liability side of the Balance Sheet:

*Capital employed 
= Total Equity + Long-term Liabilities + Short-term borrowings
= Total Equity + other Long-term Liabilities + Long-term borrowings + Short-term borrowings
= Total Equity + other Long-term Liabilities + Total borrowings



How do you work out the ROCE?

ROCE = return on capital employed

Numerator equals earnings produced for all capital providers = normalised EBIT

Denominator includes debt and equity contributed to the business. This is also the money invested into the business.

ROCE is usually calculated using a company's average capital employed over a period of two years. 

ROCE = ( EBIT / average Capital Employed)   x 100%




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The mathematical equations:

Total Asset = Total Liabilities + Total Equity

FA + CA = CL + NCL + Eq

(FA + CA - CL) = (NCL + Eq)

(FA + CA - CL) + STBorrowings = (NCL + Eq) + STBorrowings

(FA + CA - CL) + STBorrowings = (LTBorrowings + Other LTLiabilities + Eq) + STBorrowings

(FA + CA - CL) + STBorrowings = (LTBorrowings + STBorrowings + Other LTLiabilities + Eq)

#Total assets - CL + STBorrowings = Total Borrowings + Other LTLiabilities + Equity

or

*FA + NWC + STBorrowings = Total Borrowings + Other LTLiabilities + Equity



#Capital employed = Fixed asset + Current Asset - Current Liabilities + Short-term borrowings

*Capital employed = Fixed asset + Net Working Capital + Short-term borrowings

Return on Capital Employed

For example:

Capital employed $5 million
Annual profit after tax $1 million
Return on capital employed 20%

The profit may be expressed before or after tax.

Capital employed is the net amount invested in the business by the owners and is taken from the Balance Sheet.

Many people (including Warren Buffett) consider this the most important ratio of all.

It is useful to compare the result with a return that can be obtained outside the business.

If a bank is paying a higher rate, perhaps the business should be closed down and the money put in the bank.

Note that there are 2 ways of improving the return.  In the example above:

• the return on capital employed would be 25% if the profit was increased to $1.25 million.
• it would also be 25% if the capital employed was reduced to $4 million.

Which company is cheaper? (Understanding P/E, Earnings yield and EBIT/EV.)

Consider two companies, Company A and Company B.

They are actually the same company (i.e. the same sales, the same operating earnings, the same everything) except that Company A has no debt and Company B has $50 in debt (at a 10% interest rate).

All information is per share

Company A

Sales                     $100
EBIT                         10
Interest expense          0
Pretax Income           10
Taxes @ 40%             4
Net Income               $6


Company B

Sales                     $100
EBIT                         10
Interest expense           5
Pretax Income             5
Taxes @ 40%             2
Net Income               $3


The price of Company A is $60 per share.
The price of Company B is $10 per share.

Which is cheaper?

P/E of Company A is 10 ($60/6 = 10).  The E/P or earnings yield, of Company A is 10% (6/60).
P/E of Company B is 3.33 ($10/3 = 3.33). The E/P or earnings yield of Company B is 30% (3/10).

So which is cheaper?
Using P/E and earnings yield, Company B looks much cheaper than Company A.

So, is Company B clearly cheaper?


Let's look at EBIT/EV for both companies.

Company A
Enterprise value (Market price + debt)   60 + 0 = $60
EBIT   $10


Company B
Enterprise value (Market price + debt)   10 + 50 = $60
EBIT   $10

They are the same! Their EBIT/EV are the same.

To the buyer of the whole company, would it matter whether you paid $10 per share for the company and owed another $50 per share or you paid $60 and owed nothing?

It is the same thing!

*You would be buying $10 worth of EBIT for $60, either way!




Additional note:

* For example, whether you pay $200k for a building and assume a $800k mortgage or pay $1 million up front, it should be the same to you.  The building costs $1 million either way!

[Using EBIT/EV as your earnings yield provide a better picture than E/P, of how cheap or expensive the asset is.]

Pretax operating earnings or EBIT (earnings before interest and taxes) was used in place of reported earnings because companies operate with different levels of debt and differing tax rates. Using EBIT allowed us to view and compare the operating earnings of different companies without the distortions arising from the differences in tax rates and debt levels.  For each company, it was then possible to compare actual earnings from operations (EBIT) to the cost of the assets used to produce those earnings (tangible capital employed) and to the price you are paying.

Returns on Capital
= EBIT / (Net Working Capital + Net Fixed Assets)

Earnings Yield
= EBIT / EV
= EBIT / Enterprise Value

As an investor, you are looking for companies with high Returns on Capital and selling for a bargain or high Earnings Yield (EBIT / EV).

REF:  The Little Book that still Beats the Market by Joel Greenblatt

Buffett would always take rates of return on total capital into account

RETURN ON CAPITAL IS VERY IMPORTANT

The example early on this page shows that debt financing can be used to increase the rate of return on equity. This can be misleading and also problematical if interest rates rise or fall. This is probably one reason why Warren Buffett prefers companies with little or no debt. The rate of return on equity is a true one and future earnings are less unpredictable. 

A careful investor like Buffett would always take rates of return on total capital into account. The average rates of return of capital in the companies in Berkshire Hathaway portfolio are:

Coca Cola	39.12
American Express	13.68
Gillette	25.93

A comparison of the rates of return on equity and capital for these three companies is significant and the reader can make their own calculations.

COMPANY RATES OF RETURN ON EQUITY

It is significant that the majority of companies in the Berkshire Hathaway portfolio in 2002 all had higher than average returns on equity over a ten-year period. For example:

Coca Cola	45.05
American Express	20.19
Gillette	40.43

What rate of ROE does Warren Buffett look for?

WHY WARREN BUFFETT THINKS THAT RETURN ON EQUITY IS IMPORTANT

Just as a 10% return on a business is, all other things being equal, better than a 5% return, so too with corporate rates of returns on equity. 

• Also, a higher return on equity means that surplus funds can be invested to improve business operations without the owners of the business (stockholders) having to invest more capital. 
• It also means that there is less need to borrow.

WHAT RATE OF RETURN ON EQUITY DOES WARREN BUFFETT LOOK FOR?

This is a fluctuating requirement. 

• The benchmarks are the return on prime quality bonds and the average rate of returns of companies in the market. 
• In 1981, Buffett identified the average rate of return on equity of American companies at 11%, so an intelligent investor would like more than that, substantially more, preferably. 
• Bond rates change, so the long-term average bond rate must be considered, when viewing a long-term investment.
• In 1972, Buffett implied that a rate of return on equity of at least 14% was desirable. 

Although, at times, Warren Buffett has appeared to downplay the importance of Return on Equity, he constantly refers to a high rate of return as a basic investment principle.

COMPANY RATES OF RETURN ON EQUITY

It is significant that the majority of companies in the Berkshire Hathaway portfolio in 2002 all had higher than average returns on equity over a ten-year period. For example:

Coca Cola	45.05
American Express	20.19
Gillette	40.43

Why Warren Buffett thinks that ROE is Important

Warren Buffett believes that the return that a company gets on its equity is one of the most important factors in making successful stock investments.

DEFINING EQUITY

Benjamin Graham defines stockholders equity as:

‘The interest of the stockholders in a company as measured by the capital and surplus.’

CALCULATING OWNER’S EQUITY

Investors can think of stockholders equity like this. An investor who buys a business for $100,000 has an equity of $100,000 in that investment. This sum represents the total capital provided by the investor.

If the investor then makes a net profit each year from the business of $10,000, the return on equity is 10%:

10,000 x 100
  100,000

If however the investor has borrowed $50,000 from a bank and pays an annual amount of interest to the bank of $3500, the calculations change. The total capital in the business remains at $100,000 but the equity in the business (the capital provided by the investor) is now only $50,000 ($100,000 - $50,000).

The profit figures also change. The net profit now is only $6500 ($10,000 - $3,500).

The return on capital (total capital employed, equity plus debt) remains at 10%. The return on equity is different and higher. It is now 13%:

6,500 x 100
  50,000

The approach to financing its operations by a company can obviously affect the returns on equity shown by that company.

WHY WARREN BUFFETT THINKS THAT RETURN ON EQUITY IS IMPORTANT

Just as a 10% return on a business is, all other things being equal, better than a 5% return, so too with corporate rates of returns on equity. 

• Also, a higher return on equity means that surplus funds can be invested to improve business operations without the owners of the business (stockholders) having to invest more capital. 
• It also means that there is less need to borrow.

Buffett (1978): Commodity type businesses must earn inadequate returns except under conditions of tight supply or real shortage

In this write up, let us see what Warren Buffett has to say to his shareholders in the 1978 letter:

"The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. (Comment: Note Glove companies!)  As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital. We hope we don't get into too many more businesses with such tough economic characteristics."

The above paragraph once again highlights the fact that no matter how good the management, if the economic characteristic of the business is tough, then the business will continue to earn inadequate returns on capital. This can be further gauged from the fact that despite all the capital allocation skills at his disposal, the master was not able to turnaround the ailing textile business that he had acquired in the early years of his investing career. He further adds that such businesses have little product differentiation and in cases where the supply exceeds production, producers are content recovering their operating costs rather than capital employed.

While the comment is reserved for the textile industry, we believe it can be extended to all commodities like cement, steel and sugar. Infact, the current downturn the sugar industry is facing has a lot to do with supply far exceeding demand and this in turn is having a great impact on returns on capital employed by these businesses. The only hope for them is a scenario where demand will exceed supply.

"We get excited enough to commit a big percentage of insurance company net worth to equities only when we find 

• (1) businesses we can understand, 
• (2) with favorable long-term prospects, 
• (3) operated by honest and competent people, and 
• (4) priced very attractively. 

We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action. For example, in 1971 our total common stock position at Berkshire's insurance subsidiaries amounted to only US$ 10.7 m at cost and US$ 11.7 m at market. There were equities of identifiably excellent companies available - but very few at interesting prices."

Those of you, who are regular readers of content on our website, the above paragraph must have rang a bell or two. Indeed, time and again, in countless articles, we have been highlighting the importance of investing in good quality businesses run by honest and ethical management. That the master himself has been looking at similar qualities does go a long way in further reinforcing our beliefs. Buffett then goes on to make a very important comment on valuations and says that no matter how good the businesses are, there is a price to pay for it and he in his investing career has let many investing opportunities pass by because the valuations were just not right enough.

Comparison can be drawn to the tech mania in India in the late nineties when good companies with excellent management like Infosys and Wipro were available at astronomical valuations. While these companies had excellent growth prospects, investors had become far too optimistic and had bid them too high. Thus, investors who would have bought into these stocks at those levels would have had to wait for five long years just to break even! Hence, no matter how good the stock is, please ensure that you do not pay too high a price for it.

http://www.equitymaster.com/detail.asp?date=6/28/2007&story=2

Return on Capital Employed

Return on Capital Employed

Abbreviated as ROCE. A measure of the returns that a firm is realizing from its capital.

Calculated as profit before interest and tax divided by the difference between total assets and current liabilities.

The resulting ratio represents the efficiency with which capital is being utilized to generate revenue.