ROCE: Anchor For A Strong Portfolio

ROCE is one of the crucial ratios used for evaluating a stock's performance. Advait Dharmadhikari explains why ROCE remains one of the most important metrics in stock analysis and how this metric should be combined with other ratios to find future wealth creators.

- Advait Dharmadhikari

The art of stock analysis has witnessed a significant evolution over the last century. Finance textbooks and investors from all over the world have emphasized the importance of different metrics in financial statement analysis at different points of time. However, the last 30 years have seen a large number of investors following the Warren Buffett school of thought. He mesmerized the investment community with the concept of ‘moat’. Moat, as he describes it, is a water body around a magnificent castle that is filled with dangerous creatures like piranhas, poisonous snakes, etc. which act as a deterrent for anybody who tries to attack the castle. Thus, he described a company that has a competitive advantage in running its business as having a ‘moat’. Return on capital employed (ROCE) serves as an important metric to measure whether a company has a competitive advantage.

ROCE is measured by the formula EBIT/capital employed (capital employed can be calculated as total assets – current liabilities). ROCE measures how effectively a company is able to deploy its capital, i.e. equity, and debt, to generate returns for its capital providers. If the ROCE of a company is higher than its weighted average cost of capital, then the company has a strong and sustainable business. It means that a company can meet its obligations towards both its creditors and shareholders from its own business operations without the need for raising funds via equity or debt. If the ROCE is significantly higher than its cost of capital, the company can even fund its investments for growth on its own, resulting in a growth of earnings and the creation of shareholder value.