Personal Finance: The Name Of The ROCE

Accounting's most powerful ratio makes a case for its use as an investing tool.

Hello, my name is ROCE, Return on Capital Employed, if you have something against the diminutive, but pronounced to rhyme with rose (and not the same as roach). I like to think of myself as the Clark Kent of financial ratios. Most people who pass Clark in the street don't spare him a second look. And most people who come across any mention of my name-a rare occurrence in mainstream magazines, although I'm a regular in analyst-reports-read on as if nothing has changed. Like Clark's alter-ego, though, I'm powerful-not the kind of power that can bend steel bars and see through walls, but that which can see through rosy growth predictions, and serve as an objective measure of a company's performance.

The Flip-Side

ROCE is an ideal measure to understand the profitability of a company's business and the factors that influence this. However, in some cases, it may not be an accurate reflection of the company's performance. This is especially true for companies that have cash in hand (perhaps because of an equity issue that year). This would result in a lower ROCE. Take the case of Infosys: the company turned a profit of Rs 325 crore on a capital of Rs 833 crore (all 1999-2000 figures). But, out of the Rs 833 crore, Rs 525 crore is cash and fetches an interest of around 7 per cent. The actual capital, thus, was around Rs 308 crore (Rs 833 crore less Rs 525 crore). Hence the real ROCE was over 105 per cent.

Put simply, I reflect the ability of a company to earn a return on the total capital it employs. This last includes equity capital, reserves and surplus, and debt, and excludes capital work in progress. Mathematically, ROCE is the ratio of profit before interest and taxes (what the number-crunchers call PBIT) to the capital employed. As you can see, I am an efficiency measure of sorts: I don't just measure the profitability of a firm like some lesser ratios do; I measure the same after factoring in the amount of capital used. Let me explain this using the hackneyed a&b route. Company A makes a profit of Rs 100 crore on sales of Rs 1,000 crore and company B, Rs 150 crore on sales of Rs 1,000 crore. In terms of pure profitability ratios, B, with 15 per cent is far ahead of A (10 per cent). However, A employs Rs 500 crore of capital and B, Rs 1000 crore. Thus, A, with a ROCE of 20 per cent is actually a better performer than B (ROCE: 15 per cent).

Alright, I hear you. Of course you don't have to sit through a basic course in accounting handled by a financial ratio. No sir, you don't-not unless you want to hone your investing skills. A company that earns a higher return on every rupee it invests in the business, year after monotonous year, is certain to have a better market value than one that burns up capital to generate profits. Take a look at Silverline Industries. The company reported a net margin of over 36 per cent for FY 2000. But the return on capital employed fell from 62 per cent in FY 1999, to 24 per cent for FY 2000. Why? The company raised capital in the course of 1999: its equity went up from Rs 37.95 crore in FY 1999 to Rs 64.95 crore in FY 2000.

In the long run, it is easy to boost profits as long as capital isn't a constraint. But making more money out of less is the mark of a winner. Don't take my word for it; listen to Ramdeo Agrawal, Joint Managing Director, Motilal Oswal Securities: ''Only a handful of the 6,000-odd listed companies have been able to consistently deliver a higher return on capital (employed) year after year.''

Hear, hear! Modesty prevents me from saying more, but I am really the best measure of the overall earning potential of a company. The one measure with which I am closely aligned is a company's Price-Earnings (PE) multiple. For instance, Hindustan Lever Limited's ROCE is 70 per cent and its PE multiple is 50, while Escorts' ROCE is 13.56 and its PE multiple 6.59. In fact, both Hero Honda and Mico boasted similar net profit margins of around 8 per cent in 1999-2000. Still Hero Honda's PE multiple (24) was far higher than Mico's (13), simply because its ROCE was 72 per cent while the latter's was 33 per cent. I also come with another advantage: since I am calculated on the basis of profit before interest and taxes, I am free from any aberrations that can arise from effective tax and interest rates.

There are no benchmarks, but most analysts I know believe that if I am double the existing interest rate, the company is in good shape. Consistency is the key: don't invest on the basis of one year's ROCE, take a look at how I've behaved over at least five years before deciding to invest in a company. Between 1996 and 2000, I went on a southward journey as far as Bajaj Auto was concerned (40 per cent in FY 1996 to 20 per cent in FY 2000). Today, the company's market value is half what it was five years ago. Watch me.