Six things every investor should know about return on capital employed (ROCE)

so welcome back to my weekly video series and no prizes forgetting who spent too much time in the Sun at the weekend that was me so on to today's topic which is return on capital employed a couple of people have asked me have you covered it and the answer is no so in this short video I want to do a beginner's guide to return on capital employed a really key ratio useful for value investors and one or two other people besides and just explain what it is when it's most useful and one or two of the obvious pitfalls I'll give you three good things about it and three things to watch out for because no ratio is perfect right no more ado what is rocky return on capital employed okay well in a nutshell and I'm going to keep this little bit tight with some reference videos at the end those people find it short in a nutshell it is profit before interest and tax and the profit loss account over debt and equity capital employed so it's quite a grand sounding thing and it's usually expressed as a percentage so earnings or profit before interest in tax that those people who know their profit loss accounts is a number that appears about two-thirds the way down fairly key number over debt and equity capital employed to the contribution from the lenders under contribution from shareholders and it's normally given as a percentage okay so we could do a very straightforward example just to make sure that anyone out there who's used to dealing with different balance sheet formats isn't confused if you have a balance sheet that has for example assets of let's say 100 million in it liabilities or debt you know UK balance sheet is showing you the top half and the American viewers out there where else it there's it presented a little bit differently but any debt would be normally deducted and UK balance sheet so that will give you net assets of 90 million let's say funded with shareholder equity also of 90 million your capital employed take a UK balance sheet is 100 it's the equity and the debt all the gross assets figure if you like but it's that Plus that so very simple terms if the equity capital employed is 100 million tuck that in there skiing a bit messy now wouldn't worry about that and profit before interest in taxes 10 million straight from the profit last account 10 million around a million as a percentage is 10 percent not particularly difficult maths now it's not the math I'm too worried about because you can pick this up it's published all over the place journalist wave it around Rockies this Rockies there most of you will probably never have to number crunch it per say alright what's more important is that a useful number and how is it used okay well what is it most useful it is a particularly useful ratio some ratios are just profit and loss account you know margins for example gross margin operating profit margin great but just profitability some ratios are just balance sheet gearing for example okay focus is just on what's going on in the balanced view this one combines the two so it's one of ownio reason with small handful ratios that puts together the profit nosce on the balance sheet okay so that's his first advantage it's pretty comprehensive secondly it tries to ask a pretty big question if you put money into this business what sort of returned you get out again okay if you put money in it's either a debt or equity investor what are you get out again and ten percent by itself is that high is that low where you need some more information how much could you get people your money into a bank account for example presumably less how much you could put it into something very very risky presumably more okay so you need comparatives and it does not Alessa try to answer quite a big question very important for investors which is what the return by getting on my capital from investing in this business when Brahimi I could be investing in other businesses or in something completely different all together so that's reason number two to have rocky number three you can do some quite flash stuff with it which I'll just give you a hint of called DuPont analysis that sounds a bit grand all that saying is this you can break the ratio down this is one of those advantages to get you more information out by the business now this is the beginners guides I'm just going to give you a flavor of how that work no more than that okay that's better right now with DuPont analysis what you can do is something like this quite a neat little trick you can pull with return on capital employed imagine I had a bit more data about this firm so I had the sales figure what you can do mathematically is split out something like return on capital employed don't panic is not a big math lecture so you can say it can be expressed as P bit over sales times sales over capital employed all right because mathematically don't worry about that bit you take sales out your back to return on capital employed now why would you want to do that just to give you a flavor imagine same numbers as before for P bit capital employed so that was 10 million that was a hundred million and let's say making up the sales figure is 50 million you can put it in both sides so you can have 50 million there and you can have 50 million there now why would you want to do this okay because this all still gives you ten percent as an answer if you multiply one hundred percent at the end all right but the point is this it gives you more information what I'm saying is the P bit margin ten over fifty as a percentage is 20 percent okay and sales to capital employed 50 over 100 is 0.5 and half of 20% is 10% they storm up thinking what clever numbers why you're doing it why you doing it well is it just to illustrate this is now more information about the same company from one ratio okay Wang Zhang is its margin per sales 20% and it turns France its way its assets into sales a rate of 0.5 okay or put it another way it generates 50p of sales for every pound of capital employed so in other words it's quite high on margin and might be relatively low on sales to capital employed all right and that gives you a bit more information about the business because you start to ask questions like well should this be higher or should that be higher or is it about right for the industry and so on and so forth so that's just a flavor of something you can do with return on capital employed that you can't easily do with other ratios and it's because it has this comprehensive mix of something from the profit loss scale something from the balance sheet okay it's just a hint there and if you'd like me to do a bit more on that it's called DuPont analysis our happily we'll put in another video now I've said this is a good ratio and it is a good ratio but no ratio is perfect because notice of sharing one magic number you can just compare rocky for different businesses and pick along with the highest and walk away so let's finish the video which is three things to watch out for if you're using this ratio you read about it you see someone mentioning it and suggest you should buy a share on the back of it okay number one it's out of date as soon as you look at it capital employed is typically taken from the latest balance sheet and balance sheets are typically slightly out of date okay they've published their audited but the information won't be right up to the moment so that's just something to bear in mind secondly it doesn't really give you any feel for scale what I mean by that is if I tell you a company's got return on capital by ten percent it could be miniscule or it could be a massive multinational corporation and there's no way of knowing all right in other words a 10 percent rocky could translate into P bit of 10 million or 1 million or Tempe years don't really know so you know it's useful it tells you what's to return you're getting on capital but you can't go much further than that in terms of the overall size the business just comparing Rockies there's more information you need to know and thirdly it doesn't give you any real sense for risk I mean you might think well 20s better than 10 again clearly but what sort of risks are involved in getting your 20 so again it it almost asks as many questions as it answers but used in combination with other ratios it can be a pretty useful tool now just to wrap up other videos that might be useful particularly if you're new to this or even if you're not new and you're thinking has you done any of this stuff before anywhere well try what is a balance sheet I gave you a word about the capital employed stuff a talked about try a wise profit if I was a bit quick on the margin stuff there I have done a rate a video called what is return on equity which sits quite neatly alongside this one okay but a few people did say to me why delete an original capital employed so here's my answer I've done it now so those two would make sort of quite a neat pairing ok so those are three videos that way maybe well worth a look in addition to this one on that note I look forward to see you next week you

Channel: MoneyWeek

Views: 62,922

Rating: 4.9054651 out of 5

Keywords: ROCE, ROE, Return on capital employed, Return on equity, Investor ratios, How to pick shares, Value investing, Ratios, Du Pont analysis, deals, ratios, losses, inflation, bank, payments, claims, successful, Dividend, stocks, shares, Overtrading, profit, loss, Bid, offer, spreads, Currency, credit, Trading, Trade, Tax, trade, economy, whiteboard, tim bennett, Banking, profits, Accounting, tricks, America, banks, Asset, Purchase, Reverse, QE

Id: hfiFTZDwLlQ

Length: 10min 30sec (630 seconds)

Published: Fri Apr 26 2013