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What is ROCE and how is it calculated - The most comprehensive guide Need to Make strategic decisions - Use ROCE to guide you through Define Return on Capital Employed, abbreviated as ROCE, is ratio used to understand company’s capital efficiency, i.e. how efficient is the firm in generating profits from the capital it invests in the firm. What Formula? There are several formulas to calculate ROCE, and it depends on what one wants to use it for, what level of details are given and level of details required. Earnings before Interest and Tax/Capital Employed What Components? A. Capital Employed from Asset side of Balance sheet Capital employed = Total Assets – Current Liabilities, or Capital employed = Net Fixed Assets + Net Working Capital, where Net Fixed Assets = Gross PP&E + Additions – Disposals - Depreciation and Impairment B. Capital Employed from Liability side of Balance sheet Capital Employed = Shareholders Equity or funds + Total Debt or Net debt + Deferred Tax Liability Or, Net worth + Net Debt Or Add: If Lease is considered as Debt Where Shareholders Equity can be detailed as: Most comprehensive formula Notes 1. In case of US GAAP, remember: Add Operating Lease Liabilities and Current portion of Operating Lease to total Debt 2. Shareholders equity means Equity attributable to Parent i.e. do not add Non-controlling Interest Earnings Before Interest and Tax EBIT is what is presented in the annual report as Operating profit or EBIT = Adjusted EBIT, where adjusted EBIT calculated after removing one-time non-recurring and non-operating items of expense and income Always remember 1. Add back Non-recurring & one-time expenses, Unusual and Non-operating expenses Less Non-recurring & one-time expenses, Unusual and Non-operating incomes or gains Where can I find them - Financial Statement Linkages? Real Company Analysis - SGS Group Let’s take example, of SGS Group, a Swiss company engaged in Testing, Inspection and Certification business. We have taken numbers from annual reports from 2016 to 2022. The annual reports can be found at https://www.sgs.com/en/investor-relations Return on Capital Employed (CHF Million) Please feel free to pick your poison on which formula to use to calculate Capital Employed. The idea is simply to calculate total debt. EBIT ROCE = Adjusted EBIT / Capital Employed How to Interpret? As we can see from the example above, for every CHF 1 company employs it is able to earn operating profit on an average of 21 percent or in other words how much operating income is generated for each CHF 1. Also, important is comparison with some average or benchmark indicator. Comparison can be done in the following ways: 1. Temporal Comparison, i.e. time series trend analysis 2. Comparison with Industry benchmark 3. Comparison with Industry Average or close peers / competitors Remember when we compare ratios against any average it shall be calculated with same formula otherwise it will result in erroneous comparison. 1. Trend Analysis As can be seen from our example that SGS group has consistently performing with ROCE of above 20% except for 2020 with ROCE falling to 16% due to covid effect. 2. Comparison with Industry Average or close Peers: If you compare SGS group with its close peers like Intertek and Mistras it has faired better than Mistras but not with Intertek. Mistras ROCE Intertek ROCE Comparison with Close Peers But if we compare it with average ROCE of close peers, we find SGS Group has outperformed them by quite a margin, as seen from the table above. It is important to understand that when we compare ratio with peers/competitors, the selection of right peers/competitor is very important. Direct competitors which sell similar if not exactly same type of product or service, in terms of functionality and not form, shall only be compared. Also, when comparing peers’ careful consideration should be given about the share of fixed assets in total assets of the firm. For firms with high fixed asset as percentage of Total assets will have lower ROCE. What Strategic Implications Firms that have ROCE consistently above Weighted Average Cost of Capital (WACC) have sustainable competitive advantage. If we take the numerator of the ROCE ratio which is EBIT and break it further, we see it dependent on Price, Volume of product sold or frequency of services rendered and cost of service. Firms that can charge premium price or have lower costs will consistently perform better in terms of ROCE compared to WACC. How to forecast? To forecast ROCE we need to forecast Revenue, Operating Costs, Total Debt, and Shareholders funds. Shareholders funds are divided into key components for forecasting: 1. Share Capital 2. Treasury Shares 3. Additional Paid-in Capital 4. Share Premium 5. Reserves 6. Retained Earnings 1. Share capital can be forecasted using straight line method. If you want to get complex, then use additional funding requirement schedule. We need to create and 3-statement model to create such a schedule. We need to assume about what Debt equity ratio to find additional share capital or debt. We can also use the optimal capital structure model to forecast it. 2. Treasury Shares Treasury Shares is buy-back of shares by firms. To forecast it we can use either straight line method or look at for clues in annual reports Management Discussion & Analysis part where they discuss their plan for buy-back. But it more likely than not firms do not announce it in advance as it influences stock markets. 3. Additional Paid-in Capital Additional Paid-in capital is additional capital raised by companies. This is similar to share capital we do not need to forecast this and use the share capital schedule. 4. Share Premium If you have additional capital and assume to place at premium forecast, it using share capital requirement and premium that you will charge per share. Otherwise, use straight line forecast. 5. Reserves Reserves are divided into three types: a. General Reserve: Profits retained in business b. Specific Reserve: Like Debenture Redemption Reserve are type of reserve is maintained for a specific purpose c. Capital Reserves: Reserves created for specific purpose and can be used for that reason only Use straight line method to forecast reserves if details about specific purpose for which reserves were created not available. 6. Retained Earnings

Valuation is not just about numbers flashing across financial dashboards, but a story that follows strategy, economics, finance, financial standards, industry analysis, statistics, market research, and consumer behavior. So let's start the journey of the known and unknown about valuation, but first things first. Lets, go through the steps in valuation. This is divided into four sections: Market, Strategy, Forecasting and Finance and then connect each section to understand the Valuation numbers Market Connect Step 1: Characterize the company into an industry to which valuing company belongs Step 2: Understanding the industry characteristics - Porter Five forces Step 3: List and understand the business units into which the company that we value is divided Steps 4: Understand the consumer behavior from the market demand side for each business unit Step 5: List and analyze competitors in each business unit from the perspective of product and services, pricing, supply channels, promotion activities - The Marketing Mix Step 6: Create value and perception maps for each business unit Strategy Connect Step 1: At the corporate level, what strategy is the company following Step 2: At Business Level, what strategy is the company following and understand the elements of value it is propagating Step 3: Conduct Porter 5 forces analysis to understand the profitability of the company Step 4: Conduct competitor analysis to understand the competitive rivalry to understand the impact on revenues, costs and profitability Forecasting Connect Step 1: Forecast key financial parameters using regression or time series forecasting Step 2: Input forecasting output to forecast key financial parameters Finance Connect Step 1: Create basic layout of the valuation model Step 2: Input Historical data in the model - P&L, Balance Sheet, Cash flow statement and Schedules and notes Step 3: Understanding the accounting standards company follows to create financial numbers Step 4: Create Assumption sheet for forecasting financial statements and schedules Step 5: Input and Understand notes to accounts related to income statement, balance sheet, and cash flow statement to re-organize these statements Step 6: Re-organize income statement, balance sheet, and cash flow statement to estimate Net Profit After Tax (NOPAT) and Balance Sheet used for Discounted Cash Flows (DCF) calculation Step 7: Prepare Schedules to Accounts required to complete projected income statement, balance sheet and cash flow statement Step 8: Calculate Weighted Average Cost of Capital to discount Cash Flows Step 9: Estimate company value using Precedent Transactions and Comparable Trading Metrics Step 10: Collate Equity Research Analyst value estimates for the company Step 11: Determine value of a company using DCF methodology Step 12: Compare Valuation of company using different methods Photo Courtesy - Source: https://www.freepik.com/free-photos-vectors/business-valuation?log-in=google