What is ROCE, what is it used for, how is it calculated, and, most importantly, why is it important in trading? Here’s what you need to know.
In modern, dynamic, and ever-evolving finance, assessing a company’s solidity cannot be limited to simply observing its share price performance or raw earnings numbers. It’s necessary to look deeper, asking a central question: is a company truly capable of transforming its capital into profit?
In contexts where capital is the primary driver, such as utilities or heavy industry, the answer requires sophisticated analytical tools. Among these is ROCE, or Return on Capital Employed, which proves to be a key indicator for understanding how effectively a company uses capital, both its own and borrowed, to generate profitability.
What is ROCE? Meaning and Definition of Return on Capital Employed
ROCE, or Return on Capital Employed, is a metric that measures a company’s profitability by calculating the ratio between operating profit and invested capital, i.e., the sum of the company’s own and third-party financial resources. In other words, it shows how much operating profit is generated for every euro of capital employed.
Unlike ROE, which only considers equity capital, ROCE also includes borrowed capital, thus providing a more comprehensive assessment of the efficiency with which a company uses all its financial resources.
What is ROCE for?
ROCE is an extremely useful analysis tool for those who want to fully understand the efficiency with which a company uses its resources. First, it allows us to measure how effectively both our own capital and that obtained from external sources are used, highlighting the company’s ability to transform these resources into operating profits.
It is also a particularly suitable indicator for comparing companies in the same sector, as it allows you to go beyond simple accounting figures and assess the actual efficiency of capital management, regardless of the size or capital structure of the companies analyzed.
Another strategic use of ROCE is to compare it with the weighted average cost of capital, WACC. If ROCE is higher than WACC, it means the company is effectively creating value for shareholders. If, however, it is lower, capital management is producing a loss of value.
If all this were not enough, ROCE is also useful for monitoring performance over time. By analyzing its evolution over multiple financial years, it is possible to identify positive or negative trends and understand whether the strategies adopted are bringing concrete benefits or whether, conversely, interventions are needed to improve operational efficiency and invested capital management.
ROCE Formula and Calculation
The basic formula for calculating ROCE is quite simple and intuitive: divide operating profit, also known as EBIT, by invested capital, and multiply the result by 100 to obtain a percentage. Essentially, ROCE measures how much operating profit is generated for every euro of capital employed by the company.
EBIT represents operating profit before considering interest expense and taxes, thus reflecting the efficiency of the company’s core business without the influence of its financial structure or taxes. Invested Capital, on the other hand, is calculated by subtracting current liabilities from total assets, or, equivalently, by adding shareholders’ equity to long-term liabilities. This value represents the total financial resources made available to the company to conduct its business.
It is important to distinguish between two variants of ROCE: gross ROCE and net ROCE. Going into detail, Gross ROCE is based on EBIT and provides a pure operating efficiency measure, i.e., without considering tax effects. This allows for an assessment of the business’s performance, independent of tax policies or debt structure.
Net ROCE, on the other hand, uses NOPAT, or net operating profit after taxes. This version provides a more realistic and comprehensive view of the actual return on capital, as it takes into account the tax impact, which significantly impacts the bottom line. For shareholders and investors, net ROCE is therefore a more accurate indicator for understanding the true return on invested capital.
Practical Examples of Return on Invested Capital
To better understand the importance and how ROCE works, here are some practical examples of return on invested capital.
Example 1: Comparing Two Companies
Let’s imagine the case of two companies, Alpha and Beta, which both recorded operating profits of €1 million in the same year. However, Alpha invested €5 million in its business, while Beta invested €10 million. Calculating the ROCE, we obtain a value for Alpha of 20%, or €1 million divided by €5 million, while for Beta it is only 10%, or €1 million divided by €10 million. Although they have the same operating profit, Alpha is more efficient because it manages to generate the same result with half the capital. This means that Alpha makes better use of its available resources, which can make it more attractive to investors.
Example 2: The Careful Investor’s Choice
Suppose an investor is evaluating two companies operating in the same sector. Company C has a ROCE of 15%, while Company D achieves a ROCE of 25%. This means that, for every €100 invested in capital, C generates €15 in operating profit, while D generates €25. Although both operate in the same market, D is more efficient in deploying its resources. Over the long term, this difference can translate into faster growth in company value and higher returns for shareholders.
Example 3: Analyzing a Company Over Time
Consider a company that in 2016 had €220 billion in invested capital, with a ROCE of 25%. The following year, invested capital increased to €250 billion, but the ROCE dropped to 23%. This trend suggests that, despite the company having increased its resources, its operating return has not grown proportionately. For an investor, this could be a signal to consider whether the deployment of additional capital is actually creating value or, conversely, becoming less efficient.
ROCE and Trading: Here’s Why It’s Important
ROCE plays a fundamental role in trading because it allows investors to quickly assess a company’s efficiency in using its capital to generate profits. In a financial market where decisions often need to be made quickly, having an indicator like ROCE helps identify companies that not only generate profits, but do so effectively and sustainably over time. This is particularly important for those who practice active trading or medium- to long-term investments, as a high and stable ROCE over time can indicate solid management and a company’s ability to create real value.
Furthermore, comparing the ROCE of different companies within the same sector allows you to select stocks with better growth and return prospects. Trading based on fundamental analysis therefore uses ROCE as one of the tools for building a balanced portfolio, focusing on companies with high return on capital employed. Finally, monitoring ROCE trends over time helps detect signs of changes in management or market conditions, allowing investment strategies to be adapted promptly and informed.
Original article published on Money.it Italy. Original title: Cos’è il ROCE, come si calcola e perché è importante nel trading
