Return on Capital

Return on capital metrics are closely watched by managers and investors alike.

by Sam N Barron

Head of Research

However two metrics, Return on Invested Capital (ROIC) and Return on Capital Employed (ROCE), are often (incorrectly) conflated.

Although definitions vary, the numerator for ROCE is often defined as Operating Profit. Net Operating Profit After Tax (NOPAT) tends to be used for ROIC. On the denominator ROIC uses invested capital and ROCE uses capital employed. Invested capital is essentially the amount of capital used to support the operating business assets whilst capital employed is all the capital in the business. Invested capital is therefore a subset of capital employed.

Imagine a bus company which owns buses and runs a bus route but also holds shares in the local corner shop. ROIC would measure specifically the return made on the investment in the buses but would ignore the shares in the corner shop. Alternatively ROCE, as it considers all the capital in the business, would include both the investment in the bus and the corner shop. Thus, ROCE is a broader measure and is often considered a proxy for capital management success across the business whilst ROIC is a more targeted measure.

For both metrics, a higher number is desired as this indicates a company is gaining a greater return on a given amount of capital and is thus more profitable. Both metrics begin to gain meaning once compared to the weighted average cost of capital (WACC). I.e. if the company has created more from its allocation of capital than it had to pay for the capital, this allocation is theoretically value creating. Both metrics can also be used for comparison against peers.

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Understanding Finance

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