Decoding Financial Efficiency: ROIC vs. ROCE Explained

Let’s assume that the genesis of the idea of moat investing, as we know it, started with Warren Buffett. If we agree on this, and think he is on to something, then we should use his screening methods.

As I’ve said in other posts and pages, there is no line item on a financial statement saying moat. Sure, there are circumstantial ways of finding businesses with moat. As investors we want to work backwards toward finding where to invest our money. Remember a competitive advantage(s) can be the source of the moat around a company but management must execute to make the moat durable.

The evidence of the durability of a moat will show up in the financial statement numbers. The famed moat investors of the world all look to the same date points for evidence of a moat. Having these data points helps narrow the universe of stocks to consider. In Buffetts earliest writings he points to return on capital being an important point when analyzing an investment.

Today, many investors focus on one or both return on capital ratios – return on capital employed or return on invested capital. They are similar but not the same. Let’s get into the weeds on both and discover their similarities and differences.

Return on Capital Employed (ROCE)

ROCE is often used by businesses as a statement on the effectiveness of management. Hey, if it’s good enough for a business to use to measure its management then it’s good enough for me to do the same. So, what is ROCE?

ROCE = Earnings Before Interest & Taxes (EBIT) / Capital Employed

The first thing to note is that ROCE’s numerator is a before tax number. As for capital employed, we arrive at this number by adding total debt to shareholder equity then take away short-term liabilities. When we put this equation together we get a number that tells us the return management generated for all the capital it employed.

Return on Invested Capital (ROIC)

ROIC is more often used by investors and not so much by the business themselves. ROIC shows how efficient the company is using funds to generate a return to investors. What is ROIC?

ROIC = Net Operating Profit (NOPAT) / Invested Capital

The first thing to note is that ROIC’s numerator is an after tax number. As for invested capital this is the capital circulating in the business. We arrive at the invested capital number by adding:

short-term debt + long-term debt + lease obligations + Equity + non-operating cash = Invested Capital.

Differences between ROCE and ROIC

ROIC is a more focused ratio. This is because ROIC only considers the capital invested and actively used by the company for production of goods and services. ROIC is more useful for investors. ROIC helps investors determine the prospective returns they may receive on the capital they’ve invested.

ROCE considers all of the capital that a company employs in its business. ROCE is an indicator of the ability of the company’s management when it comes to generating revenue.

Conclusion

Screening for stocks that have high and consistent ROIC or ROCE will provide a list of companies worth further research. There is a very good chance that you will have found a list of stocks that mostly have competitive advantages over their peers.

If the world’s best investors all agree that these two ratios are something to look for then you should too.

This website and associated newsletter along with its content/links are not financial advice. Nothing in this newsletter is an investment recommendation. All content is created for entertainment, educational, or informational purposes only. My strong buy, accumulate, hold, reduce or sell opinions are exactly that – opinions. Be sure to do your own research for your own particular circumstances or higher a professional advisor.

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