Why ROCE play’s a vital role in Evaluating a Company

In our previous story, we followed the journey of Aryan, a working professional with 10 years of experience, as he explored the world of equity investing. Along his path, he met several mentors who introduced him to different aspects of investing, from fundamental analysis to technical analysis, value investing, growth investing, and dividend investing. Now, as Aryan's journey continues, he encounters a wise investor named Ravi, who opens his eyes to the importance of Return on Capital Employed (ROCE) while evaluating a company.

Aryan's encounter with Ravi begins with a captivating discussion about the key metrics that reveal the financial health and efficiency of a company. Ravi explains that while profitability is essential, it is equally crucial to understand how effectively a company utilizes its capital to generate returns. That's where ROCE comes into play.

Ravi shares a fascinating tale of a renowned manufacturing company that caught Aryan's attention. The company, under the leadership of its founder, Rahul, experienced tremendous growth and success. However, Ravi reveals that Rahul's strategic decision-making and focus on ROCE were the true catalysts behind the company's achievements.

Aryan, eager to understand more, listens attentively as Ravi explains that ROCE measures the profitability of a company's capital investments. It is calculated by dividing a company's operating profit (or EBIT) by its capital employed and expressed as a percentage. Ravi emphasizes that ROCE provides valuable insights into a company's efficiency, profitability, and potential for sustainable growth.

Ultimately, the calculation of ROCE tells you the amount of profit a company is generating per 100 Rs. of capital employed. The more profit per 100 Rs. a company can generate, the better.

As Aryan dives deeper into the concept, Ravi enlightens him about the reasons why ROCE holds such significance in evaluating a company. Here are some key insights that Aryan learns during this phase of his journey:

Efficiency and Capital Allocation: ROCE serves as a measure of how effectively a company deploys its capital to generate profits. It reveals how well a company utilizes its resources, including assets, investments, and working capital, to generate returns for its shareholders.

Comparing Companies: ROCE allows investors to compare the performance of different companies within the same industry or across industries. It provides a standardized metric to assess which companies are more efficient in generating profits from their capital investments.

Long-Term Sustainability: A consistently high ROCE indicates that a company has a strong competitive advantage, effective management, and a sound business model. It suggests that the company is capable of generating sustainable profits and may be well-positioned for long-term success.

Growth and Value Investing: ROCE plays a crucial role in both growth and value investing strategies. Growth investors look for companies with a high ROCE, as it signifies their ability to reinvest profits back into the business for future expansion. Value investors, on the other hand, seek companies with a lower market valuation compared to their ROCE, indicating potential undervaluation.

Aryan absorbs these insights, realizing that ROCE provides a comprehensive picture of a company's financial efficiency and sustainability. Armed with this knowledge, he understands that evaluating a company's ROCE alongside other financial metrics can help him make more informed investment decisions.

Disclaimer: The story of Aryan's journey is fictional and intended for educational purposes only. Equity investing involves risks, and individuals should conduct their own research and seek professional advice before making any investment decisions.

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Sumit Poddar

Chief Investment Officer & Smallcase Portfolio Manager

Tikona Capital

www.tikonacapital.com