Problems with Return on Capital Employed (ROCE)

Return on capital employed is a valuation multiple that is commonly used in order to determine the efficiency of a company. When trying to determine whether to buy a stock, many investors use this ratio as a way to help make the decision. Even though this metric provides some valuable information, there are a few potential problems with it.

Return on Capital Employed

The idea behind return on capital employed is that you can look at a company and determine how much profit is generated by the amount of money that it has used. In order to calculate the return on capital employed, you need to take the profit before interest and taxation and divide that by the amount of capital that has been employed. This will give you a number that you can use to determine how profitable a company is with each dollar that they use. 

Cash Reserves

One of the big problems with this ratio is that it does not pay any attention to the impact of cash reserves. Cash reserves are included in the amount of money that is used for the capital employed number. If a company has a large amount of cash reserves, it could skew the numbers significantly. They might be sitting on this money, but they have not actually used it for anything yet. If a company has a large sum of cash reserves, this can make it look as if it were actually less profitable or efficient than it actually is. 

Multiple Years

Many investors make the mistake of looking at the return on capital employed of a company for only one year. While it is good to see a favorable return on the capital employed ratio for a year, you want to be able to find a company that has displayed this ability over several years. By finding a company that has a good return on capital employed ratio over multiple years, you will know that you are investing in a financially sound company.

Comparing

Another mistake that many people make with this ratio is that they look at it independently. When you get the return on capital employed ratio, you need to compare it to other companies that are in the same sector or industry. Looking at the ratio is really not going to tell you that much. You need to know how that number compares to other companies that this company is competing with. A favorable ratio could simply tell you that the company is in a good industry. If you want to invest in the best company in the industry, you need to compare the ratios of multiple companies.

Historical Data

Another problem with return on capital employed is that it uses historical data. You are using numbers from the course of an entire year. When trying to make investment decisions for the future, it does not always work out to base them on past information. The company might have been profitable in the past, but they could be heading in the wrong direction.

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