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The Return on Capital Employed ratio (ROCE) tells us how much profit we earn from the investments the
shareholders have made in their company. Think of it this way: if we had a savings account with a bank
and we'd been paid, say, £25 interest at the end of a year; and we had saved £500, we could work out
the rate of interest we had earned:

Interest earned 25 1 100

c


 
= * 100 = * 100 = * 100 = = 5%
Amount saved 500 20 20

So, we have earned 5% interest on our savings.

Imagine now that instead of talking about a savings account, we were talking about a company and the
profit for the year and its capital employed had been £25 and £500 respectively then the ROCE for that
company would be 5% too.

Profit for the Year 25 1 100

c = * 100 = * 100 = * 100 = = 5%
Equity Shareholders' Funds 500 20 20

Did you notice that we use the Equity Shareholders' Funds instead of Capital Employed? In fact, they are
different names for the same thing! We could call the ratio the Return on Shareholders' Funds (ROSF)
just as easily if we wanted; but generations of accountants and students only know it as ROCE.

In accounting, there can be different definitions of what certain terms mean. The use of the term 'capital
employed' can mean different things. It can, for example, include bank loans and overdrafts since these
are funds employed within the firm. Because there are different interpretations of what ROCE can mean,
it is suggested that you use a method which you feel comfortable with but be aware that others may
interpret your definition in a different way. Below is a guide to some of the interpretations that we have
found on this issue.

  



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Elliott & Elliott: ROCE = Net profit/capital

Capital employed = total assets
employed

Capital employed = fixed assets + current assets -

Investor Words:
current liabilities

Capital employed = ordinary share capital + reserves +

investopedia.com: Return = Profit before tax
preference share capital + minority interest +
+ interest paid
provisions + total borrowings - intangible assets

TRADING capital employed = share capital + reserves +

all borrowings including lease obligations, overdraft,

Holmes & Sugden: Return = trading profit plus minority interest, provisions, associates and
income from investment and company share investments

of the profit of associates OVERALL capital employed = share capital + reserves +

all borrowings including lease obligations, overdraft,
minority interest, provisions

Capital employed = total fixed assets + current assets -

DTI
(current liabilities + long term liabilities + provisions)

Capital employed = fixed assets + current assets -

Johnson Matthey Annual Report & Accounts
(creditors + provisions)
Let's calculate the ROCE for the Carphone Warehouse now; and here are the figures we need:

       

    

Profit for the financial period 38,159 16,327

Equity shareholders' funds 436,758 44,190

Off you go!

Did you get this?

What do we think of these results? Well, the question we have to ask is

"Could we have earned more money (profit) if we had invested in a different business or simply put our
money in the bank?"

Well, interest rates at the bank were somewhere around 4 or 5% in 2001 so we did better than that; but
there are many businesses that have a ROCE of higher than 8 or 9%. Still, in 2000 the Carphone
Warehouse had an ROCE of almost 37%: that's very good by all standards.

So what went wrong between 2000 and 2001? What happened, it didn't necessarily go wrong, was that
the capital employed increased from £44,190,000 to £436,758,000 (a 10 fold increase) BUT the profits
increased from £16,327 to only £38,159... they only just about doubled.

It's no surprise then that the ROCE fell so sharply as capital employed increased 5 times faster than the
profit did.

It will be interesting to see what 2002 brings for the Carphone Warehouse and their ROCE.

We will look at Vodafone's ROCE shortly, but for interest here are some other ROCE values to compare
with the Carphone Warehouse:

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 $


 
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c 5.56% 3.16% -12.12% -0.12% 33.63% 16.17% 16.14% 16.29%



Again, these other ROCE values demonstrate that not everyone can get the same results for the same
ratio at the same time: it depends on the industry, the management, the economy and so on.

The ROCE results in this new table relate to the Carphone Warehouse's results for the year ended 25
March 2000 of 36.95%. This is a good result as it shows that the business is effectively earning around
37% on the (investment) funds that the shareholders have invested in it.

Contrast the other ROCE values with the Carphone Warehouse and we can see that only the discount
airline has a ROCE value anywhere near it. The international airline's ROCE is extremely low at just over
3%. Wouldn't the shareholders be better off selling the business and putting the money in the bank as it
would earn more than that?

We should also compare these ROCE values with the profitability values. Let's just compare net
profitability with the ROCE.

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(( %


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%

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Net 7.36% 4.05% -10.48% 1.63% 10.87% 12.63% 7.55% 27.15%
Profit

ROC 5.56% 3.16% -12.12% -0.12% 33.63% 16.17% 16.14% 16.29%

E

Putting the data from this table on a graph can help us to see if there is a relationship between them:

There does seem to be a relationship between the net profit margin and the ROCE: the higher the net
profit margin, the higher the ROCE. After all, the curve on this graph is not a straight line and it might
even be a true curve meaning that the relationship is more complex than we might think. Keep an eye
on this relationship whenever you assess the profitability of a business

YYY

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Discounted cash flow

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Excel spreadsheet uses Free cash flows to estimate stock's Fair Value and measure the sensibility of
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equation can be solved for , that is the internal rate of return.

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To show how discounted cash flow analysis is performed, consider the following simplified example.

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Simple subtraction suggests that the value of his profit on such a transaction would be $150,000 í
$100,000 = $50,000, or 50%. If that $50,000 is amortized over the three years, his implied annual
return (known as the internal rate of return) would be about 14.5%. Looking at those figures, he might
be justified in thinking that the purchase looked like a good idea.
3
1.145 x 100000 = 150000 approximately.

However, since three years have passed between the purchase and the sale, any cash flow from the sale
must be discounted accordingly. At the time John Doe buys the house, the 3-year US Treasury Note rate
is 5% per annum. Treasury Notes are generally considered to be inherently less risky than real estate,
since the value of the Note is guaranteed by the US Government and there is a liquid market for the
purchase and sale of T-Notes. If he hadn't put his money into buying the house, he could have invested
it in the relatively safe T-Notes instead. This 5% per annum can therefore be regarded as the risk-free
interest rate for the relevant period (3 years).

Using the DPV formula above (FV=$150,000, i=0.05, n=3), that means that the value of $150,000
received in three years actually has a present value of $129,576 (rounded off). In other words we would
need to invest $129,576 in a T-Bond now to get $150,000 in 3 years almost risk free. This is a
quantitative way of showing that money in the future is not as valuable as money in the present
($150,000 in 3 years isn't worth the same as $150,000 now; it is worth $129,576 now).

Subtracting the purchase price of the house ($100,000) from the present value results in the net
present value of the whole transaction, which would be $29,576 or a little more than 29% of the
purchase price.

Another way of looking at the deal as the excess return achieved (over the risk-free rate) is (14.5%-
5.0%)/(100%+5%) or approximately 9.0% (still very respectable). (As a check, 1.050 x 1.090 = 1.145
approximately.)

But what about risk?

We assume that the $150,000 is John's best estimate of the sale price that he will be able to achieve in
3 years time (after deducting all expenses, of course). There is of course a lot of uncertainty about
house prices, and the outcome may end up higher or lower than this estimate.

(The house John is buying is in a "good neighborhood", but market values have been rising quite a lot
lately and the real estate market analysts in the media are talking about a slow-down and higher
interest rates. There is a probability that John might not be able to get the full $150,000 he is expecting
in three years due to a slowing of price appreciation, or that loss of liquidity in the real estate market
might make it very hard for him to sell at all.)

Under normal circumstances, people entering into such transactions are risk-averse, that is to say that
they are prepared to accept a lower expected return for the sake of avoiding risk. See Capital asset
pricing model for a further discussion of this. For the sake of the example (and this is a gross
simplification), let's assume that he values this particular risk at 5% per annum (we could perform a
more precise probabilistic analysis of the risk, but that is beyond the scope of this article). Therefore,
allowing for this risk, his expected return is now 9.0% per annum (the arithmetic is the same as above).

And the excess return over the risk-free rate is now (9.0%-5.0%)/(100% + 5%) which comes to
approximately 3.8% per annum.

That return rate may seem low, but it is still positive after all of our discounting, suggesting that the
investment decision is probably a good one: it produces enough profit to compensate for tying up capital
and incurring risk with a little extra left over. When investors and managers perform DCF analysis, the
important thing is that the net present value of the decision after discounting all future cash flows at
least be positive (more than zero). If it is negative, that means that the investment decision would
actually ›
 money even if it appears to generate a nominal profit. For instance, if the expected sale
price of John Doe's house in the example above was not $150,000 in three years, but 
 in three
years or $150,000 in  years, then on the above assumptions buying the house would actually cause
John to ›
 money in present-value terms (about $3,000 in the first case, and about $8,000 in the
second). Similarly, if the house was located in an undesirable neighborhood and the Federal Reserve
Bank was about to raise interest rates by five percentage points, then the risk factor would be a lot
higher than 5%: it might not be possible for him to predict a profit in discounted terms even if he thinks
he could sell the house for  in three years.

In this example, only one future cash flow was considered. For a decision which generates multiple cash
flows in multiple time periods, all the cash flows must be discounted and then summed into a single net
present value.
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This is necessarily a simple treatment of a complex subject: more detail is beyond the scope of this
article.

For these valuation purposes, a number of different DCF methods are distinguished today, some of
which are outlined below. The details are likely to vary depending on the capital structure of the
company. However the assumptions used in the appraisal (especially the equity discount rate and the
projection of the cash flows to be achieved) are likely to be at least as important as the precise model
used.

Both the income stream selected and the associated cost of capital model determine the valuation result
obtained with each method. This is one reason these valuation methods are formally referred to as the
Discounted Future Economic Income methods.


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Discount the cash flows available to the holders of equity capital, after allowing for cost of servicing debt
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Disadvantages: Requires judgement on choice of discount rate


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capital finance

Disadvantages: Requires judgement on choice of discount rate; no explicit allowance for cost of debt
capital, which may be much higher than a "risk-free" rate

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Derive a weighted cost of the capital obtained from the various sources and use that discount rate to
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Disadvantages: Care must be exercised in the selection of the appropriate income stream. The net cash
flow to total invested capital is the generally accepted choice.

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This distinction illustrates that the Discounted Cash Flow method can be used to determine the value of
various business ownership interests. These can include equity or debt holders.
Alternatively, the method can be used to value the company based on the value of total invested capital.
In each case, the differences lie in the choice of the income stream and discount rate. For example, the
net cash flow to total invested capital and WACC are appropriate when valuing a company based on the
[1]
market value of all invested capital.

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Commercial banks have widely used discounted cash flow as a method of valuing commercial real estate
construction projects. This practice has two substantial shortcomings. 1) The discount rate assumption
relies on the market for competing investments at the time of the analysis, which would likely change,
perhaps dramatically, over time, and 2) straight line assumptions about income increasing over ten
years are generally based upon historic increases in market rent but never factors in the cyclical nature
of many real estate markets. Most loans are made during boom real estate markets and these markets
usually last less than ten years. Using DCF to analyze commercial real estate during any but the early
years of a boom market will lead to overvaluation of the asset.

Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a mechanical
valuation tool, which makes it subject to the axiom "garbage in, garbage out". Small changes in inputs
can result in large changes in the value of a company. Instead of trying to project the cash flows to
infinity, terminal value techniques are often used. A simple annuity is used to estimate the terminal
value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the
cash flows as time goes on. [1] involves calculating the period of time likely to recoup the intial outlay .

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