Why is Return On Capital Employed so important
Return on Capital Employed is one of the most important metric which i think you need to look while making an investment decision. Return on Capital Employed is simply the earnings which the management makes out of the money which is invested in the business. Return on Capital Employed also helps you to vouch for the efficiency by which a management manages the money which is allocated to it (i dont have to mention that it is shareholders money which the managers are using).
For a more accurate view of how to calculate Return on Capital you can watch this investopedia video or (for data savers simleps1010 doesn’t want to leave anyone right) visit here for the text –
(if the video doesn’t play for any reason you can go to YouTube directly by clicking on the vidoe headline)
I don’t like to deduct dividends for calculating the ratio.
When a company earns profit it has two major options-
– return the Money to Shareholders through dividends or Buybacks.
– Reinvest it in the company for future expansion of the business.
The managers are entrusted by the shareholders with job of proper capital allocation which can lead to disastrous consequences if not properly done. There have been wide cases of Management misusing the money for worthless acquisitions without any benefit. There will be a whole lot of analysts who will make fancy presentations and show off their PowerPoint skills on how does the acquisition will help the business in the future. The most common line for deals is that It will help in creating synergies in the future. i don’t know what sort of synergies are being created by paying a foolish price for such a business or by buying a business which the manager doesn’t know how to run as it is completely unrelated with the business which is being run currently by the management. Everyone has there own circle of competence whether you accept it or not. The shareholders don’t benefit by such deals due to an eventual reduction in the value of the business and the bankers, who would just add some percentage points to i guess the three words in the banking industry NPA and over to that they will also incur recovery costs for the loan which at the first place shouldn’t have been sanctioned. Then come the rating agencies with their ratings which are downgraded after the company has made a default. Does that sort of a rating has any meaning when the company has already defaulted on the same. There can be only only one person who might benefit from this process which maybe the investment banker who explain all the things to both the parties and will get a commission if the deal happens. This whole should be pictured in a movie with a very fancy story so i guess there is atleast someone who would benefit from the act.
You might be knowing about the famous amtek auto crisis which happened in India which is pretty much an example of how can you misuse money. You can read about it here . It is like you buy the asset with some money and the later you sell the same asset to recover less money you paid to buy ( i guess i deviated form the topic but it was pretty much necessary.)
Managers should return the money to the shareholders if they don’t get any way to compound it at high rates of return in the business.
Only increasing the EPS is not useful. To show this suppose you have Rs 10000 at the end of certain year. You make a profit that year of Rs 1000 and reinvest the profit in the business and for the next year you earn Rs 1100 which is not any outstanding job as the rate of return you are earning on your money still remains the same 10% although you have increased your profits. The increase in profits also comes with an increase in your capital which is not good. A simple bank savings account or a bond also does the same thing if you choose to reinvest for interest. This is very simple right. The key lies in earning more with the same capital and that is pretty much why return on capital employed is very much important. Once again there is a need to say that there should be a sustainable high return on capital employed and not an extraordinary year of very high return on capital employed. Actually an year with a high return on capital employed eventually is the cause for the misuse of capital employed due to the high cash generated from operations in that year and to add to that there is the banker who sometimes love the Central Bank guidelines on NPA’s and they think it is compulsory to be atleast something in NPA’s just i guess to check the how the guidelines look when they are implemented.
In the case i have assumed that the firm has minimal amount of debt and hence return on capital employed and return on equity shareholders fund will be approximately the same number as there is minimal interest cost. In case of high debt in the firm the return on net worth or equity shareholders fund can be significantly higher (if at all there is any return left after servicing the mountain of debt). You can however use return on equity shareholders fund if you think it is appropriate. Both however show the return on money used by the firm. You can see the below screenshots for the return on capital employed of brinatania industries which has minimal amounts of debt and hence return on capital employed and return on net worth are sort of same.
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