What does return on capital mean and how do you calculate it?

Q. What does return on capital mean and how do you calculate it?

Arriving at a rational decision over whether to invest in a particular stock is not easy, so investors have devised various ratios to help their analysis. Probably the most familiar is the price-to-earnings ratio, but although the p/e is simple to understand and useful, it says nothing about the quality of the business concerned.

For that, we need to know the return on capital, which measures how effectively a business uses the money invested in it.

What is the return on capital?

Return on capital is a way to measure the profitability of a business. Simply put, it compares a company’s profits with the value of the assets used to produce them. It answers the question ‘how many pence in profit will the company generate from each £1 worth of assets?’.

Inevitably, the investment community has found ways to complicate this straightforward-sounding idea. There is more than one measure under the general heading of ‘return on capital’; each has its advantages and disadvantages but we don’t intend to inflict all of them on readers. Instead we will plump for one, which is called ‘return on capital employed’ or ROCE. (Similar measures include ‘return on invested capital’ or ROIC and return on equity.) ROCE is popular among certain professional investors who use it to help identify what they regard as ‘quality’ companies.

How do you calculate a company’s return on capital employed?

To work out the ROCE we divide the company’s returns by the amount of capital used to make them, then multiply by 100 for a percentage figure. For ROCE, a specific definition of ‘return’ is used: we want the earnings before interest and tax, or ‘EBIT’. EBIT is usually regarded as a reflection of the aspects of a business under managers’ direct control.

‘Capital’ also has a particular definition for the purposes of calculating ROCE. It is the total value of everything the company possesses, whether ‘tangible’ (its buildings, machinery and so on) or ‘intangible’ (such as patents and brands), minus certain liabilities. Although a company’s long-term debts (such as the values of any bonds it has issued) are not deducted, we do subtract the value of its short-term borrowings. Fortunately, these are normally disclosed separately in a company’s annual report and accounts.

Worked example

We’ll calculate the ROCE figure for Tesco and will first need to calculate the ‘return’. We’ll use the figures in its annual report and accounts, which are checked by the company’s independent auditors. In the accounts for the year to 24 February 2024, in the ‘group income statement’ on page 129, we see that Tesco does not disclose a figure for earnings before interest and tax (some companies do). This is not too big a problem: we can either use Tesco’s figure for ‘operating profit’ (profits before consideration of interest costs and interest income), which is not normally too dissimilar from EBIT, or look up the EBIT figure elsewhere.

Tesco discloses an operating profit figure of £2.8bn for the year to February. If we visit the Tesco page at morningstar.co.uk, we find a figure for EBIT of £3.1bn.

Now we need to work out the ‘capital employed’ figure. The numbers we need are found in the group balance sheet on page 131 of the annual report or on the ‘financials’ tab of the Tesco page at fidelity.co.uk, for example. First, we find the figure for total assets, which is £47bn, then for current liabilities, which is £20.5bn. We subtract the latter from the former to arrive at a figure for capital employed of £26.5bn.

We then divide EBIT of £3.1bn by capital employed of £26.5bn to arrive at an ROCE figure of 11.7%. 

How to use the return on capital figure

In essence, the higher the ROCE figure, the more profitable the business. Some professional investors who use the ‘quality’ approach prefer businesses that make a return on capital of at least 10% and ideally more.

In any event you want the return on capital to be more than the business’s ‘cost of capital’. Cost of capital can be a tricky concept to grasp. When we are dealing with capital supplied by debt it’s easy enough: the cost is the interest rate. If the capital comes from the issue of shares, its cost is in essence the expected return investors demand for putting their money into the business. Some fund managers choose to cut through the complexities and the inevitable volatility in the cost of capital and simply assume a figure of 10% over an economic cycle, hence the need for ROCE to exceed that figure.

It’s important that the return on capital be sustainable, so it’s a good idea to look back over the figures from the past few years.

A key aspect of return on capital is that it has no connection with the share price: it relates only to figures intrinsic to the business, figures that would be the same whatever the share price was or even if the business was not listed at all. The ROCE figure therefore says nothing about the valuation of the stock. So, before you invest in a company simply because it can boast a sustainably high return on capital, consider the stock market valuation too, perhaps via the price-to-earnings ratio.

We should always remember too that less scrupulous businesses can and do find ways to massage their financial results. An unreliable figure for EBIT would lead to an unreliable figure for return on capital (although EBIT tends to be less tainted by attempts at ‘creative accounting’ than other measures). One easy-to-spot red flag in company accounts is if sales, profits and cash flow do not move broadly in the same direction over a number of years.

ROCE figures may also reflect the industry sector that a company belongs to and its capital needs. A software company, for example, typically needs less capital than a large industrial business and so its return on capital is likely to be higher. This may also in part explain why some IT companies enjoy a higher stock market valuation relative to profits than an industrial business that may need significant investment year after year.

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Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Please be aware that past performance is not a reliable guide indicator of future returns. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.