Want to know if the company you are considering has the potential to do well? Then look at a ratio of the company's pre-tax operating earnings to its tangible capital, or the Return on Capital employed (ROCE) Ratio.

Return on Capital Employed (ROCE) Ratio is one of the important tools used to identify companies that offer good value and have the potential to grow. The ROCE ratio helps to identify good businesses that earn more relative to the price being paid than others.

Return on Capital Employed Formula

The Return on Capital Employed formula is:

ROCE Ratio = EBIT/(Adjusted Net Working Capital + Net Fixed Assets).

There are several ways to determine if it is a good business. Measures include Return on Invested Capital, Return on Assets (ROA) and Return on Equity (ROE). I like to use a variation of the Return on Capital Employed Ratio, as the measure of the pre-tax operating earnings to tangible capital employed.

ROCE Ratio Definition

The ROCE Ratio definition is a measure of the returns a company derives from its capital. It is calculated as profit before interest and taxes divided by tangible capital employed. The resulting ROCE ratio presents how efficient capital is being used to generate pretax profit.

Pre-tax operating earnings are often called Earnings Before Interest and Taxes (EBIT). Interest is excluded as companies can operate with different levels of debt. The interest charges on this debt can and does skew the comparative earnings of a company. Also, companies can operate with different tax levels which can also skew the comparative earnings of a company. Removing these two financial line items gives us a better measure of the operating profits generated by the company. These line items are readily available from the company's income statement either on their investor relations section of their site or through such sites as finance.yahoo.com.

Tangible capital employed is defined as the Net Working Capital + Net Fixed Assets. Working capital is the difference between the Current Assets and the Current Liabilities of the company. These line items are easily obtainable from the company's balance sheet as well as sites such as finance.yahoo.com.

Net Working Capital is used because a company must fund its receivables and inventory but does not have to pay money for its payables, as these are effectively an interest-free loan, as long as they are paid off within the terms of their specific agreement. Excess cash and short term investments are also excluded, since they are not used to help run the current operations of the company. Do not get me wrong, cash is good. It is just that any cash not needed to run the business should not be part of the assessment of how well the company is performing, as it has not yet been invested in operating assets of the company. The idea is to use the actual capital the company has invested in its business.

In addition, a company must fund the purchase of fixed assets necessary to conduct its business such as real estate, plant and equipment. The depreciated cost of these fixed assets is added to the net working capital requirements to derive the estimate for tangible capital employed.

Return on Capital Employed Example

Let’s look at two examples of the ROCE ratio from very different industries. The first one is Accenture (ACN) the large consulting and outsourcing firm. The other is EMC Corporation (EMC) the data storage company. Both are large companies with EMC in the technology manufacturing business and Accenture the consulting and outsourcing business, a service industry. The financial numbers are from February 28, 2007 for Accenture and December 31, 2006 for EMC. While the sources for these numbers are the SEC filings of each company, investors can also use financial sites such as finance.yahoo.com which readily displays these line items.

Earnings Before Interest and Taxes is the sum of the latest 12 months results. The Adjusted Net Working Capital excludes Cash & Short Term Investments to exclude from Total Current Assets is the only one requiring some judgment. Remember that Excess Cash and Short Term Investments are excluded, since they are not used to help run the current operations of the company. In other words, cash is being subtracted because it does not yet represent operating assets. How much is excluded is based on what leaves the company with sufficient Net Working Capital. In ACN’s case this only included Short Term Investments. Excluding all the cash would have created a negative Adjusted Working Capital making the ROCE Ratio not meaningful. For EMC it was possible to exclude their large Short Term Investments and all their Cash.

One of the reasons ACN has a much higher ROCE ratio is that they are a service firm, while EMC is a manufacturer. EMC requires substantially more Property, Plant and Equipment than ACN. Using only this measure an investor would chose ACN over EMC. However, there are more factors to consider. The Return On Capital Employed Ratio is just one factor to help find quality stocks.

Other indicators that help to evaluate Growth At a Reasonable Price (GARP) investing include the Earnings Yield, Free Cash Flow, Cash Flow Yield, Free Cash Flow Yield and Free Cash Flow Multiple.

We include Return on Capital employed Ratio as part of our evaluation of stocks under consideration for our model portfolios that have beat the market since our inception on January 2006.