ROCE: Value or Quality?

Research
1

All,

I think I just need to catch up on Marc’s courses over the weekend. But I took his discussion of value and quality seriously so I was looking at quality ratios.

ROCE (return on capital employed) = EBIT/Capital employed. That does not look that different from EBITDA/EV.

Is EVITDA/EV a value ratio? Is ROCE a quality ratio? Is there always a big separation?

Another example: ROE does not seem all that different from Earnings (actually net income) to marketCap which begins to look like total earnings/marketCap which reduces to earnings per share/price per share or E/P. So the only real difference is the use of net income versus earnings. Is that enough of a difference that one is clearly value and the other is clearly quality?

Serious overlap?

Thanks and sorry to the more advanced for the basic question.

2

Given the way everything evolves from a common (DDM) starting point, you should not be surprised to notice things like that and in fact, you should be pleased; it means you’re tuning into the big picture.

What ROCE does is, in a sense, the same as what PE does or how dividend yield works; you’re expressing a relationship between a measure of periodically generated wealth and the based on capital with which that wealth is associated. That association is always there.

The variations are conveniences for ourselves. In some cases, they help us focus on a definition of wealth that is particularly meaningful to us. For some, those who want a significant portion of investment return to be as quick and tangible as possible, that’s the dividend. At one time, that was the dominant factor. Nowadays, we tend to take a longer view that is highly tolerant of corporate reinvestment, meaning the focus on EPS. Others, focusing on forecasting challenges, move higher up the income statement to EBITDA, gross income, or sales, and others prefer a different accrual-free focus and go to cash flow. One way or anther, though, this is all about assessment of recurring wealth generation.

The same can be said of the other part of the fraction, the capital base. Customarily, when we use words like “value,” we’re market oriented and gravitate toward price or market cap, which relates most directly to what we actually have to pay. But again, we’re forecasting the future and that’s hard so we also can and do use other concepts we think may be more stable and predictable. So we can look at the based on business capital – book value, total assets. And there’s EV, which is a hybrid of business and personal measures of capital. Book value is obviously challenging in its own right due to its accounting heritage, so some like to adjust it, for example by subtracting intangibles.

So yes, you can describe ROCE as a value ratio, the distinction being you’re measuring value at the enterprise level rather than in the equity market. There’s a lot to be said for both and what we use (or whichever combination) is based on ourselves and how we’re choosing to look for clues about the future. Marketplace-oriented clues tend to be more here-and-now and have come under the “value” linguistic umbrella. Items like ROCE tend to be more big-picture and have come under the “quality” linguistic umbrella.

So actually, that “basic” question isn’t really so basic after all. It shows that you’re seeing fundamental items in a new and much more powerful way. You’ve stepped beyond the popular jargon and are now seeing what’s real.

3

Thank you Marc. I started one of your online courses and I will catch up on both.

4

Good thread.
One thing I have noticed over time is that the universe of stocks you are considering interact with efficiency/valuation metrics in different and sometimes erroneous ways. Banking industry stocks are the poster child but as I was reading about employed capital, it talked about misleading ROCE for companies with a lot of depreciated assets, like older companies. So the takeaway I always have now is thinking of the companies being considered and what are the appropriate metrics for them. I don’t want to be too specific but also don’t want to measure company performance inaccurately.

5

The major difference–an obvious one–between ROCE (or other quality measures) and valuation measures is the price factor. A company can have exactly the same ROCE over years while having a huge difference in price from one time to another. The same is true for ROE. The key is to buy the company when its price is low and to sell it when its price is high, and a company with a strong ROCE may be more likely to accomplish that shift in price than one with low or negative ROCE. In other words, while ROCE has a relationship to EBIT/EV in the numerator, the difference in the denominator is huge.

I favor occasionally substituting quality ratios for similar value ones. For example, I prefer EBITDA to total debt over EBITDA to EV. The former tells me about the ability of the company to pay off its debt; the latter, for me, muddies that issue with a good measure of market cap, which has nothing to do with that ability. Similarly, I’d rather look at three different growth indicators and three different value indicators than to combine a few of them into a PEG ratio. Sometimes these ratios just get too complicated. The beauty of P123’s ranking systems is that we can take all these factors into account at once by ranking them at the same time, which was harder to do back when complex ratios like PEG and EBITDA/EV were first developed.

6

Thanks Yuval. This helps correct my misunderstanding of “shareholder equity.” I had thought that it was basically market cap (which would have been a function of price). This is obviously not correct. I copied the definition but I will not paste it here as you already know it. I will look at EBITDA to debt.

@ David: that makes sense about ROCE. Much appreciated.

I obviously do not know much about quality ratios yet. I appreciate everyone’s comments.