Author Topic: Question about ROCE and Book Value  (Read 1155 times)

MikeTheCannon

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Question about ROCE and Book Value
« on: November 11, 2017, 06:05:06 PM »
I’ve got a quick accounting question I was hoping you guys could help me with. I’m trying to calculate Return on Capital Employed for a company. But, more importantly, I’m trying to figure out how Price-to-Book-Value interacts with ROCE.

Here’s a quick hypothetical example:

Return on Capital Employed = (Operating Income)/(Capital Employed)

Assuming Operating Income = $100

Assuming Capital Employed = $950

Return on Capital Employed = 10.52%

This ROCE is for the value of the capital employed by the company but not necessarily by an investor. That is, the cost of purchasing the company’s “capital employed” today is dictated by the stock price, which leads me to believe I should also be considering the price-to-book-value when looking at ROCE. For example, if the P/B value was 1.5 I would be spending 1.5 times the value of the “capital employed” to receive the same operating income which drives down the return:

Assuming Operating Income = $100

Assuming Capital Employed = $950

Assuming P/B = 1.5

Return on capital employed to someone buying the stock = (100)/(950 x 1.5) = 7.01%

Alternatively:

Assuming P/B = 0.8

Return on capital employed to someone buying the stock = (100)/(950 x 0.8 ) = 13.16%

Is this wrong? I’ve been toying with the idea for a bit and I think it’s right but my accounting knowledge is pretty limited. Now, I realize that “capital employed” and “book value” are not the same, but I figure they’re closely related in this context. The amount of leverage within the company would also affect this. But assuming that the capital structure is 100% equity would this make sense?
Thanks!


LC

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Re: Question about ROCE and Book Value
« Reply #1 on: November 11, 2017, 07:26:05 PM »
Well remember, book value is simply the cost of the assets at time of purchase, less accumulated depreciation. There are two issues: (1) the price of a company's assets may have risen or dropped since the company purchased it, and (2) depreciation may or may not reflect current economic reality.

The general idea is "how much would it cost to replicate this company's operations". That is the true "capital employed" number. I think one (if not the best) measure of a company's profitability would be: owner's earnings/replication cost.
« Last Edit: November 11, 2017, 07:28:07 PM by LC »
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Cigarbutt

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Re: Question about ROCE and Book Value
« Reply #2 on: November 12, 2017, 06:22:59 AM »
LC's answer is straight to the point.
What you're looking for is not entirely clear.

At any rate, here's some potentially relevant info.
https://www.aaii.com/computerized-investing/article/return-on-capital-employed.pdf
http://people.stern.nyu.edu/adamodar/pdfiles/papers/returnmeasures.pdf

The second link is authored by Mr. Damodaran. More conceptual.
The first link refers to a skinny book that you may find in a separate private communication and that is more practical.
If you're short on time, the appendix section is where the juice is.
« Last Edit: November 12, 2017, 06:26:08 AM by Cigarbutt »

MikeTheCannon

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Re: Question about ROCE and Book Value
« Reply #3 on: November 12, 2017, 07:34:57 AM »
Well remember, book value is simply the cost of the assets at time of purchase, less accumulated depreciation. There are two issues: (1) the price of a company's assets may have risen or dropped since the company purchased it, and (2) depreciation may or may not reflect current economic reality.

The general idea is "how much would it cost to replicate this company's operations". That is the true "capital employed" number. I think one (if not the best) measure of a company's profitability would be: owner's earnings/replication cost.

LC's answer is straight to the point.
What you're looking for is not entirely clear.

At any rate, here's some potentially relevant info.
https://www.aaii.com/computerized-investing/article/return-on-capital-employed.pdf
http://people.stern.nyu.edu/adamodar/pdfiles/papers/returnmeasures.pdf

The second link is authored by Mr. Damodaran. More conceptual.
The first link refers to a skinny book that you may find in a separate private communication and that is more practical.
If you're short on time, the appendix section is where the juice is.

Thanks for the responses and the links! I'll be sure to read them.

Also, sorry for the  confusion about my post. Simply put, I'm trying to find companies with ROCE of 15%.  I have realized, however, the the price you pay for a company (and thus indirectly the "capital employed") has the ability to amend the "return on capital employed to the investor". For example:

Income = $100
Capital Employed =$950
ROCE = $100/$950 = 10.52%

If you pay $950 for $950 worth of capital employed your ROCE is going to be the same as the company's: 10.52%. But! If you are somehow able to buy that same "capital employed" for $800 (despite it showing up on the balance sheet as $950) your ROCE will differ from the company's: the company's will remain at 10.52% but the investor will have an ROCE of 12.5%. Of course, the opposite will hold true too: paying $1100 for the $950 of capital employed will decrease the investor's ROCE to 9.09% while the company's remains at 10.52%.

Does that make sense? More importantly, are there any pitfalls I'm over looking? The big reason I'm trying to do this is to compare my opportunity cost across multiple companies. One company might have an ROCE of 7% but selling at a discount while another has an ROCE of 20% but is selling at a major premium. I'm trying to bring these two opportunities back to a single number ("ROCE to the investor") in order to be able to compare them with a bit more ease.

- Mike

« Last Edit: November 12, 2017, 07:43:04 AM by MikeTheCannon »

racemize

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Re: Question about ROCE and Book Value
« Reply #4 on: November 12, 2017, 07:48:51 AM »
Well remember, book value is simply the cost of the assets at time of purchase, less accumulated depreciation. There are two issues: (1) the price of a company's assets may have risen or dropped since the company purchased it, and (2) depreciation may or may not reflect current economic reality.

The general idea is "how much would it cost to replicate this company's operations". That is the true "capital employed" number. I think one (if not the best) measure of a company's profitability would be: owner's earnings/replication cost.

LC's answer is straight to the point.
What you're looking for is not entirely clear.

At any rate, here's some potentially relevant info.
https://www.aaii.com/computerized-investing/article/return-on-capital-employed.pdf
http://people.stern.nyu.edu/adamodar/pdfiles/papers/returnmeasures.pdf

The second link is authored by Mr. Damodaran. More conceptual.
The first link refers to a skinny book that you may find in a separate private communication and that is more practical.
If you're short on time, the appendix section is where the juice is.

Thanks for the responses and the links! I'll be sure to read them.

Also, sorry for the  confusion about my post. Simply put, I'm trying to find companies with ROCE of 15%.  I have realized, however, the the price you pay for a company (and thus indirectly the "capital employed") has the ability to amend the "return on capital employed to the investor". For example:

Income = $100
Capital Employed =$950
ROCE = $100/$950 = 10.52%

If you pay $950 for $950 worth of capital employed your ROCE is going to be the same as the company's: 10.52%. But! If you are somehow able to buy that same "capital employed" for $800 (despite it showing up on the balance sheet as $950) your ROCE will differ from the company's: the company's will remain at 10.52% but the investor will have an ROCE of 12.5%. Of course, the opposite will hold true too: paying $1100 for the $950 of capital employed will decrease the investor's ROCE to 9.09% while the company's remains at 10.52%.

Does that make sense? More importantly, are there any pitfalls I'm over looking? The big reason I'm trying to do this is to compare my opportunity cost across multiple companies. One company might have an ROCE of 7% but selling at a discount while another has an ROCE of 20% but is selling at a major premium. I'm trying to bring these two opportunities back to a single number ("ROCE to the investor") in order to be able to compare them with a bit more ease.

- Mike

That is true in the short term, but over the long term, the returns of a business approach the returns on actual capital employed (not the price you paid for it).  So, while you might get 15% initially, it will drop to 10% over time if that is what the business is able to generate on invested capital.

MikeTheCannon

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Re: Question about ROCE and Book Value
« Reply #5 on: November 12, 2017, 09:00:48 AM »
That is true in the short term, but over the long term, the returns of a business approach the returns on actual capital employed (not the price you paid for it).  So, while you might get 15% initially, it will drop to 10% over time if that is what the business is able to generate on invested capital.

Fair point! I guess this would be a bit akin to buying a bond at a discount/premium to par value.
« Last Edit: November 12, 2017, 10:25:38 AM by MikeTheCannon »

John Hjorth

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Re: Question about ROCE and Book Value
« Reply #6 on: November 12, 2017, 09:06:37 AM »
Mike,

What Joel [racemize] is posting in a very dense post above, is that your investment horizon matters a lot to the calculations you are doing. It's covered in one of the Essays written by Joel, which you can find here. The Essay relevant for this discussion is the Essay called Price and Return, dated December 31 2015.

In short, the longer your investment horizon is, the more important for your investment outcome the long term ability of the company to generate return on equity is, and the less important the price paid becomes, and vice versa.

- - - o 0 o - - -

Edit: You beat me to it, Mike. I'll post the full post anyway, because of the links provided, which may be of interest to you.
« Last Edit: November 12, 2017, 09:35:44 AM by John Hjorth »
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MikeTheCannon

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Re: Question about ROCE and Book Value
« Reply #7 on: November 12, 2017, 10:26:48 AM »
Mike,

What Joel [racemize] is posting in a very dense post above, is that your investment horizon matters a lot to the calculations you are doing. It's covered in one of the Essays written by Joel, which you can find here. The Essay relevant for this discussion is the Essay called Price and Return, dated December 31 2015.

In short, the longer your investment horizon is, the more important for your investment outcome the long term ability of the company to generate return on equity is, and the less important the price paid becomes, and vice versa.

- - - o 0 o - - -

Edit: You beat me to it, Mike. I'll post the full post anyway, because of the links provided, which may be of interest to you.

Absolutely they're of interest to me! Thanks for keeping them posted!