Investors looking to put money to work with a company for the long term often employ fundamental analysis, which involves scrutinising financial metrics and analysing financial statements to help them understand how fundamentally strong a company is. While profit margins are a solid indicator of a good or bad business, the margin doesn’t tell you anything about how much money a company actually spent to generate its sales and profits.

This is where two popular ratios used to identify high quality companies come in, namely ROCE (return on capital employed) and ROIC (return on invested capital). In short, these measures tell you how good a company is at getting a decent bang for its buck.

WHAT IS ROCE?

One measure often employed by top fund managers, among them Fundsmith Equity’s (B41YBW7) Terry Smith, and investment analysts, is the ROCE, which Phil Oakley, author of How To Pick Quality Shares, says is one of the best ways to work out what he describes as a company’s interest rate – i.e. the return it earns on the money invested in its projects. The higher this interest rate is, the better the business tends to be.

Just as you might look for a savings account with the highest or high rate of interest, it makes sense to look for companies that generate high rates of return. 

Quality-focused investors such as Warren Buffett and Terry Smith seek out companies with a high and sustainable ROCE or ones they think will eventually have a high ROCE.

To generate value for its shareholders a business should generate a ROCE which is consistently ahead of its weighted average cost of capital (WACC). In plain English, this means it needs to make a bigger return on the money spent funding the business than the average cost of that funding (from both debt and equity).

A good rule of thumb is that a ROCE of 15% or more is reflective of a decent-quality business and this is almost certain to mean it is generating a return well above its WACC. The higher the percentage figure, the better. It usually signals a company has a competitive advantage over its rivals, as it can make more money from putting the same amount of capital to work. A high double-digit figure often means the company has a defensible edge versus its competitors, for example a strong brand or a unique product.

APPLYING THE ROCE TO A REAL-WORLD EXAMPLE

Spirax (SPX), the West Country engineering outfit specialising in thermal energy management and niche pumping specialist, reported an operating profit of £284.8 million for the year to December 2023. In the same set of results, it reported shareholders’ equity of £1,156.9 million and non-current liabilities of £1,096.7 million.

CALCULATE THE RETURN

Operating profit = £284.8 million

CALCULATE CAPITAL EMPLOYED

*Shareholders’ equity = £1,156.9 million

*Non-current liabilities = £1,096.7 million

*Shareholders’ equity + non-current liabilities = £2,253.6 million

PUT IT TOGETHER

£284.8 million/£2,253.6 million = 0.126 x 100 = 12.6

ROCE = 12.6

Spirax actually has its 2023 ROCE at 41.6% but it uses a different formula to come up with this number.

HOW TO CALCULATE THE ROCE

ROCE measures how effectively a company uses its total capital employed to generate income. It is calculated as the operating profit divided by the capital employed, multiplied by one hundred (see Spirax example).

ROCE is made up of two parts: the return and the capital employed. The most widely-used measure of return is operating profit. The capital employed bit is the money needed to keep a business running and can be measured by combining shareholders’ funds with debt liabilities. Shareholders’ funds, also known as total equity or shareholders’ equity, encompasses all a firm’s assets both tangible (such as a factory) and intangible (anything from a brand to a piece of intellectual property) minus any liabilities. You can find both the shareholders’ equity and a company’s non-current liabilities, an effective proxy for its interest-bearing debt, in the annual accounts statement.

WHAT DRIVES A HIGH ROCE?

Companies with a high ROCE often have relatively modest capital requirements to fund their growth. This might be because their business is largely conducted online so it doesn’t have the overheads associated with, for example, maintaining and adding to a physical footprint.

Examples include property portal Rightmove (RMV) and second-hand car marketplace Auto Trader (AUTO), while franchise businesses such as Domino’s Pizza (DOM) often generate a high ROCE since their franchisees take on a decent chunk of the capital burden. Companies which consistently increase their ROCE over the years demonstrate they are creating value for their shareholders, making them compelling investments.

WHAT IS ROIC?

A company’s ROIC is different. It is a measure of how efficiently a company generates cash flow compared to how much capital is invested in the company and is calculated by taking its operating profit after tax and dividing by the total amount of capital invested and expressing the result as a percentage.

ROIC is the ultimate measure of profit and performance and a main driver of free cash flow, which is ultimately what investors are after. A company with a higher ROIC will have a lower reinvestment rate than a firm with a lower ROIC, and will need to reinvest less capital to achieve the same level of earnings growth.

High ROIC businesses generate so much free cash flow they can finance their growth internally rather than relying on outside capital to grow. This means less debt or less equity dilution for shareholders and they can invest more in new initiatives to build new moats and new profitable growth streams over time.

ROIC is the favoured metric of Liontrust’s Global Innovation team, co-headed by James Dowey and Storm Uru, who are supported by Clare Pleydell-Bouverie and James O’Connor, a quartet who seek to generate strong returns by investing in innovative companies. Their core belief is innovation is the single most important driver of stock returns. As Pleydell-Bouverie explains: ‘With ROIC, you’ve got profits on the numerator divided by all the investment it takes to generate those profits on the denominator, so it really signals the strength of companies’ barriers as well as their future cash generation.’

SIMILARITIES & DIFFERENCES

Both metrics gauge how well a company’s capital is being employed to run the business, but there are significant differences between the two ratios. ROCE is a more specific return measure than ROIC, but it is only useful when comparing companies within the same industry, whereas ROIC is a bit more flexible, as it can be used to compare products, but also projects and various investment opportunities.

It is also worth noting that because ROCE measures return against the book value of assets, depreciation can affect ROCE even if cash flow is constant. This is not the case with ROIC.

Another key difference between ROIC and ROCE is that ROCE is based on pre-tax figures while ROIC is based on figures after tax. Thus, ROCE is more relevant from the company’s perspective, while ROIC is more relevant from the investor’s perspective because it gives them an indication of what they are likely to get as dividends.

David Beggs, fund manager at Sanford DeLand, says both measures ‘should be highly correlated to each other and there is no harm in using both as a point of comparison. If there is a material difference between the two it’s an invitation to dig deeper to understand why.’ Beggs adds: ‘Also, arguably more important than the absolute level of ROIC or ROCE is the incremental return being achieved – that’s looking at how much additional profit is being made on the additional capital that has been invested in the business over say a three or five year period. This can be a great leading indicator.’ 

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