For Part 2 into understanding roce/roic of a business - roce/roic although by general definition sounds very simple, I.e the returns a company is generating on its invested capital, sounds very simple prima facie and a bit similar to ebit/op margins. However - contd.
Remember this "capital employed" Is the money employed for buying the raw materials, for funding capex growth etc. So in a way this doesn't show much about the value addition that a company does to its raw materials (which operating/ebit margins does).
So roce is a measure of EFFICIENCY of a business and it gives idea about both the nature of product AND also how well is the company able to deploy its capital right to sell MORE OF IT. I know sounds a bit confusing but lets do the dupont (I.e breakdown of roce into simple parts
Let's just stick with the turnover part and the earnings as% of sales (which is nothing but ebit/opm discussed in the last tweet) so roce not only contains the ebit margin but also the "turnover" Part - which is our key focus here. Let me simplify it even further contd.
Roce is return on capital employed. I.e EBIT/CAPITAL EMPLOYED. But capital employed is nothing but money that was invested from {(reserves+share capital) + debt} i.e (internal accruals + debt funded capital) - so roce is nothing but Return on MONEY INVESTED. That's all you have
To remember - now let's go deeper roce is ebit/CE which can be mathematically written as (EBIT/SALES) * (SALES/CE). Sales cancels each other and we are left with ebit/CE right where we started. Ebit/sales has already been discussed as operating margins, now our focus is on
SALES/CE, which is also known as TURNOVER. In a way just simply understand if CE turnover is high, company uses lesser money to generate HIGHER SALES and vice versa. Let us understand with 2 examples - First is DMART
DMART
Even if DMART is a low operating margin business (7-9%),they have to maintain lowest cost to beat the competition. But look at their roce - double digits (16-25%). How is this possible ? Simple. CE TURNOVER - Understand the business of dmart. Since it buys/sells its
Products in bulk - it can but products on credit at a cheaper price as well! Thus it doesn't have to pump a lot of capital to keep buying new products! In a way it uses its power as a large buyer to make it's business more capital efficient, and thus the double digit ROCES
Second example - APL APOLLO, Which is nothing but a steel converter. Now this is an excercise for you - Look at operating margins and the roce of business and use the same logic as dmart. Hope this helped. Thank you for reading 🙏🏻 do share what you have found.
I think not a lot of people understand the difference between two very important return ratios : operating margins and roc/roic. Both seem very similar but there's a huge difference. Both have their own merits that help you understand the key competitive advantage of any business
Operating margin/ebitda margin simply means how much value a company can add to its raw materials to sell the final product. It has two key elements - sales and (cogs+sga). So if a company has high ebidta margins it simply means two things :
1. That the company is able to
Cut costs efficiently or is able to make products that are difficult to make or need some process expertise (if everybody could make it the the cost would drop). For this two examples come to mind - look at cos like Divis and clean science. They have been able to maintain 30%+