INVESTING EXPLAINED: What you need to know about ROCE

In this series, we debunk the jargon and explain a popular investment term or theme. Here it is ROCE.

Another abbreviation. What does this stand for?

The letters stand for return on capital employed – a measure of a company’s profitability based on the amount of capital invested in the company.

It is calculated by dividing profits before taxes and interest by the sum of equity and long-term debt, that is, the capital provided by creditors.

ROCE shows how well managers are putting money to work in the company – a task that many consider their primary responsibility.

Who is a fan of this?

Many successful fund managers consider ROCE to be an excellent way to assess whether it is worth investing in a company.

Warren Buffett and Charlie Munger, the non-agenarian bosses of the US Berkshire Hathaway fund, and Fundsmith’s Terry Smith are just some of those putting their faith in ROCE.

Lately, Buffett and Munger don’t seem to have seen too many good ROCE opportunities. As announced last weekend, their fund’s cash pile is a record $157 billion.

What is a decent ROCE score?

THE higher the ROCE, the better. Some investors aim for a ROCE of at least 15 percent, while others push for 20 percent or more.

This eliminates a large number of businesses, especially at a time of higher interest rates when the cost of borrowing makes it harder for even a successful project to earn a decent return.

When is the statistic most useful?

The ROCE is useful when comparing companies in the same sector. For example, airline Jet2 currently has a ROCE of 16.2 percent, compared to 1.6 percent for competitor EasyJet.

Shell’s ROCE stands at 16 percent, compared to an oil giant average of around 11 percent.

When is it less useful?

The metric provides less insight when comparing companies across industries. Some companies, such as those in aviation, mining, telecommunications and utilities, require much more capital than others.

Certain types of companies have much lower capital requirements, such as property portal Rightmove, which relies largely on its website and apps. The ROCE stands at 339.18 percent.

How does ROCE differ from ROE?

Return on equity (ROE) attempts to show how efficiently a company generates profits. It is calculated by dividing net profit by shareholders’ equity. Since some argue that there are ways to produce a more flattering ROE, ROCE is considered a somewhat superior metric.

Does a high ROCE mean a high stock price?

In theory this should be the case, although it is not always the case. But it is a guide to whether a company you invest in is trying to get the most out of your money.

There is an ongoing debate on this issue, with Next being one of those involved. In its report and annual accounts, the retailer says its aim is to ‘create value and make profits’.

It adds: ‘We do not make ‘strategic’ investments, we invest for returns on our shareholders’ money. All our activities must strive towards this in one way or another.’

Next’s ROCE stands at 32.18 percent, compared to 2.85 percent for online rival Asos. In the past year, the Next share price has risen by 39 percent. Asos shares have fallen 39 percent.