ROCE: A Great Tool to Start the Stock Screening Process

When a company starts a business, it requires capital. This capital consists of equity (i.e. the owner's contribution) and debt. The capital is required to buy assets such as plants and machinery, office and factory space, and other important assets to start and run a business.

These assets generate cash flows and earnings. Since there is no such thing as a free lunch, capital invested also has a cost involved. This includes the cost of equity and cost of debt, which is interest cost. This is weighted in proportion to their share in the total capital structure which is known as weighted average cost of capital or WACC.

Now, if you have to gauge company's performance, it makes sense to compare its WACC with the quantum of cash flows or earnings generated by the investment. This is the return on capital employed (ROCE).

Now, why it is important to look at ROCE? Imagine a company's WACC is 14%, but earns a return on its capital of only 10%. What does this mean? Companies with low return of capital require continuous external infusions of capital to fund their growth. This creates no value for equity investors. In fact, the company is destroying the wealth of its shareholders.

Now, imagine a company with a WACC of 12% but generating ROCE of more than 20%. This company is creating wealth for its shareholder by generating excess returns. Now we must ask a very important question: Why is the company generating an excess return on capital? What is the reason?

Go deep enough, and one will find that the company has some structural or competitive advantage. It might be the company's brand name, distribution network, robust business model, niche specialisation, strong entry barriers, switching cost barriers for customers, or low production costs. Similarly, it also shows good capital allocation skills of the management.

The formula for ROCE is EBIT divided by capital employed.

EBIT is earnings before interest and tax.

Capital employed is the shareholder's equity and debt liabilities.

I have put a filter of 20% ROCE and came across following companies:

It is important to note that the above companies posted decent topline and bottomline growth over the years. They also have some competitive advantage over their rivals. However, this is just a starting point. One must dig deeper - into the historical performance of the company for the last, say, ten years - to find the source of the company's competitive advantage. One must also look at the valuations before considering buying the stock.

Now let's look at another list. I have put a filter of ROCE below 10%. Similarly, I have added other filters such as the debt-to-equity ratio and interest-coverage ratio to check how companies are performing on these parameters. Here is the result:

The above companies are earning ROCE less than WACC. They are also highly levered with low or negative interest coverage ratios.

ROCE is a great tool to start the stock screening process. It helps to filter out poor stocks in the first place. However, it is just that: a starting point.