What is the EV/Capital Employed Ratio?
EV/Capital Employed Ratio is a measure of enterprise value normalized by the level of capital used by the business. For example, a large business with a large capital stock is bound to realize a large enterprise value solely due to its large capital holdings.
What Does the Numerator (ROCE) Mean?
- Earnings before interest tax (EBIT): It is the net operating profit of the business and can be calculated by adding interest and tax payments to the income. The figure is shown in the income statement as shows all the profits generated by the company.
- Capital employed: It is the total amount of capital invested in the business. It is calculated by subtracting the total assets by the total liabilities or adding the fixed assets and working capital.
The ROCE ratio measures how much profit a company can generate with the total capital in the business; that is, how many dollars of profit each dollar spent on capital has generated. For example, if the ROCE is 0.5, it means that for every dollar invested by the company, 50 cents of profit has been generated.
ROCE is a profitability ratio that measures the return on the assets in the company in comparison to its financing over a long period of time. The long-term profitability value that ROCE provides is a major reason why many stakeholders use it to measure the long-term growth and performance of the company. It shows if the capital employed by the company is being used efficiently and is in line with their long-term strategies.
The rate of return must be higher than the rate of borrowing. If it is not, then the company is losing money. The amount of capital employed also affects the return. A company can own a small number of assets but report large profits, which can result in a high ROCE vs. a company with a large number of assets and the same amount of profits.
A business (Company ABC) reports an EBIT of $250,000. The business holds total assets of $150,000 and total liabilities of $85,000. The ROCE, in this case, will be:
The ROCE of the business is 3.85. It essentially means that for every dollar invested in the business, the business earns a return of $3.85.
What Does the Denominator (EBIT/EV Multiple) Mean?
The EBIT/EV multiple is a financial ratio that compares the EBIT (which can be an estimate or a historical figure) to the Enterprise Value. It determines the value of similar companies in an industry. This measurement for the earnings yield was developed by Joel Greenblatt at the Columbia Business School.
- EBIT (EBIT) – It allows investors to assess the core operations of the business without worrying about the costs of the capital structure.
- Enterprise Value (EV) – The value of a company. It looks at the ownership of all assets from both debt and equity. The EV can be considered as the cost of buying a company. It can be calculated as EV = Market Capitalization + Market Value of Debt – Cash and Equivalents.
One of the major benefits of using the EBIT/EV multiple is that it reflects the claims of debt and equity holders in a company. Therefore, it is able to identify companies that carry too much debt and not enough cash. It is useful information that is not reflected in the P/E ratio.
Another important advantage is that using EBIT instead of net income reduces any effect that different tax rates may have on the profitability of the business. It also allows you to compare the capital structures of companies. It makes it easier to compare two companies with different tax rates and different debt levels.
The enterprise value in the denominator takes into account the value of debt and the market capitalization. However, the EBIT/EV multiple does not take into account depreciation and amortization, which can distort the profitability of a company as different companies use different depreciation methods.
A business (Company ABC) sees an EBIT of $20,000. The business also reports a market capitalization of $120,000, debt value of $30,000, and cash in hand of $10,000.
Therefore, the EV Capital Employed Ratio of Company ABC is 3.85 * 7 = 26.95.
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