The risk with ROCE focussed investing

As an investor, understanding the profitability of a business is a key measure to track. We need to know if the business is profitable and preferably measure it over a longer period of time. It is in fact a critical metric in the analysis of a company, providing insights into its financial performance from an investment perspective.

ROCE or Return on Capital Employed is defined as earnings before interest and tax (EBIT) divided by the value of the capital employed. It essentially represents the value of the capital (typically total assets minus current liabilities) that the company uses to generate the EBIT. It quantifies how adeptly a business is deploying its capital to generate profits. A higher ROCE signals a machine firing on all cylinders, signifying a more efficient use of capital to generate profits. This makes ROCE an indispensable filter to screen out mediocre or inefficient companies.

While this is the best point to filter out companies, it can often be a blind spot in the process. It can be a myopic trap. It is excellent for validating past performance but woefully inadequate for spotting the big winners of the future. Screening companies based on a certain ROCE score also means weeding out some potential winners of the future. Especially for new-age businesses that require a lot of upfront capital investment in order to build scale and momentum. And that brings us to the key point: will over-fixation on ROCE take our eye off the multi-baggers of the future? ROCE is an excellent metric when analyzing mature industries or categories. But in high-growth new-age businesses, there could be an extended period of low ROCE followed by exponential growth. It is during this period that investors face a challenge when using ROCE as a key metric.

Click Here

Investing is not about rewarding past efficiency; it is about identifying and getting into the game early, thus capturing future value creation. Estimating the future performance of a company requires a forward-looking lens that ROCE just cannot provide. ROCE tells us how well the company has done in the past, but estimating the future is the crystal ball that needs to inform us about how well the company will do in the future. Despite an excellent ROCE, a forward-looking view can identify future disruptions to the industry or company. It is often subjective, based on several what-if scenarios and one’s view of the possible outcomes in each scenario.

In summary, over-fixation with ROCE could blind us to multi-baggers. But ditching it also brings its own risks. It makes sense to use ROCE as a baseline filter in the case of established industries. However, in the case of new-age businesses, using ROCE may be dangerous. New-age businesses need to be viewed differently, with a higher emphasis on future scenarios and assumptions. 

Click Here