Understanding ROCE (Return on Capital Employed) for Investing

The recent Capitalmind article on Return on Capital Employed (ROCE) is really worth reading. ROCE is a metric that indicates how well a company earns returns from capital invested. This is important to consider when looking for a high-quality company to invest in.

Here’s how to see it, using the same example as in the article.

Restaurant A: Upscale, high investment, high prices, low net income, low ROCE.
Restaurant B: Modest, low investment, lower prices, high net income, high ROCE.

Most of us are interested in eating at Restaurant A, but when it comes to true business and investment, we will prefer Restaurant B because the business makes more profits.

A long-term analysis of over 800 companies operating ten years ago to better understand the relationship between ROCE and returns over time. The companies were classified into ten deciles based on their three-year average ROCE at the time (with 1 being the worst and 10 being the best).

ROCE doesn’t stay the same for companies over a long period. For example, if a company was in the top 10% for ROCE (really good) ten years ago, only 4 out of 10 of those companies were still in the top 10% one year ago.

The table shows the movement of companies across deciles over a ten-year period. You need to read it row-wise.

When it comes to the improvement and worsening of ROCE. The majority of companies that showed improvement in their ROCE were actually in the lower deciles initially. This points out that companies starting from a lower performance level had more room for improvement and were able to enhance their ROCE over time.

The top 34 ROC decile companies from a decade ago are still there.

Again, companies with a high past ROCE didn’t always deliver the highest shareholder returns.

Companies that maintained consistent ROCE over time tended to have better long-term returns. The more consistent a company’s ROCE, the higher its long-term returns were.

I suggest you to read the entire article for more insights, charts, and detailed information: The impact of Return on Capital on Shareholder Returns » Capitalmind - Better Investing