What Drives A High Return on Capital Employed (ROCE)?
- Rupam Deb
- Dec 7, 2023
- 3 min read
Updated: Nov 7, 2024
Warren Buffett once said, “The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine.”
High returns on capital. That’s the secret to compounding, for both the value of the business and your wealth as a shareholder!
So, what actually drives high return on capital, for example, a high return on capital employed (ROCE)?
Components Of High ROCE
We can examine the sources/ components of high ROCE, through the lens of DuPont analysis (which is actually used for breaking down the components of ROE).
Let’s start with breaking down the formula of ROCE.
ROCE
= Operating profit / Capital employed (CE)
= (Operating profit / Revenue) x (Revenue / CE)
= Operating profit margin (OPM) x CE turnover
Voilà! Either high operating profit margin, or high CE turnover.
Or a combination of both! That’s the path to high ROCE.
Differentiation vs Cost Leadership Strategy
When a company deploys capital at a high ROCE (in running its business), above its cost of capital, it is creating (excess economic) value, which is not an easy feat to do, sustainably over a long period of time in this capitalistic economy.
Broadly speaking, there are two strategies that companies can pursue to create such excess value.
First, the differentiation strategy, where a company can try to produce goods or services that are different from others (and valued by the customers), such that they can charge prices that are high enough for them to earn a high profit margin.
Second, the cost leadership strategy, where a company can try to achieve large scale and volumes for its business, and have lower costs of sales than the competitors, such that it can charge prices that are below its competitors, but compensate for the low profit margins with efficient use of capital in generating very large amounts of revenues.
The first strategy (differentiation) would lead to high OPM.
The second strategy (cost leadership) would lead to high CE turnover.
And either of the two above could help the company to generate high ROCE and create value.
Examples Of Companies Achieving High ROCE
Let’s look at some real examples of companies with high ROCE (covered in our Multibagger Research Series program) to help us understand these better.
As seen in the chart below, all the 6 companies had high ROCE of around 18% to 32% in FY2022, with the exception of Amazon with a low calculated ROCE of 4%, which was depressed due to its heavy reinvestments (on purpose).
Notes: (1) FY2022 means financial year 2022, which refers to the year ending December 2022 (except for Wise, with its year ending March 2023). (2) The ROCE calculated includes goodwill amount in the capital employed. If we exclude goodwill from the capital employed, some companies had much higher ROCE (e.g. 55% for Evolution, and 91% for Adobe), and we will discuss this topic of ROCE including or excluding goodwill in the future.
Although all the companies had high ROCE, they had achieved the high returns through very different paths.
As a start, we have Evolution, which had a relatively low CE turnover (of 37%). However, it had such a high OPM (of 62%, which was the highest among the 6 companies covered in the chart), that it still managed to achieve a high ROCE of 23% (or actually, even much higher, at 55% ROCE (& a higher CE turnover of 89%), if we exclude goodwill from the capital employed amount, which is a different topic we will discuss in the future).
Next, we have Adyen, with a higher CE turnover (50%) but a lower OPM (50% too, coincidentally), thus achieving a ROCE of ~25%.
The next 3 companies:
had even higher CE turnover – Hermès (79%), Adobe (90%) and Wise (110%);
but lower OPM – Hermes (41%), Adobe (35%) and Wise (16%); thus
achieving reasonably high ROCE of 32%, 31% and 18%, respectively.
Lastly, Amazon had the highest CE turnover (167%), with a very low OPM (2%), leading to a low ROCE of 4%, which was artificially depressed.
So, as you can see from these 6 companies, different roads lead to high-ROCE Rome, with some having:
high margins, through differentiation in values offered, like Evolution and Adyen;
low margins, but high efficiency in terms of CE turnover, like Wise and Amazon; and
both reasonably high margins and also CE turnover, like Hermès or Adobe.
Our Conclusion on Achieving High Return on Capital Employed (ROCE)
We hope you’ve enjoyed our discussion on ROCE in this article here! In our MoneyWiseSmart courses, we dive much deeper into these concepts for our subscribers.
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