Lemonade Parade II
How to Adjust ROCE for Valuation and Factor in Time
In the last article we compared the Return on Capital Employed (ROCE) of two stocks I hold: Somero Enterprises (SOM.L) and Water Intelligence (WATR.L). Somero Enterprises was clearly a far superior stock to Water Intelligence based on ROCE, even after adjusting for cash and goodwill. But in order to make a truly fair comparison, we have to factor in the price you pay and consider how ROCE has changed in the past and may change in the future - its trajectory.
What are you paying for?
Here are two lemonade stands you can buy:
The Fresh Squeeze: has a ROCE of 35%
The Zesty Zing: has a ROCE of 75%
The second is the better business by ROCE, so which should you buy? It’s hard to say without seeing the price you’re paying, right? The same is true for stocks.
We have to factor the price you pay into our calculations. To do that, we’ll divide enterprise value by the net income of the business to get an EV to earnings multiple. Let’s call it EV/E. It’s sort of like the price to earnings ratio (PE ratio). We’ll then divide our EBT (PBT) used in the ROCE calculation by EV/E before we use it in our ROCE calculation. This will adjust the returns used in our ROCE calculation by the price you pay for them. EV/E includes taxes as it’s based on net income, but you could use PBT, EBIT, EBITDA, or any other numerator as long as you are consistent and it gives a fair comparison.
Using enterprise value takes into account the net cash of the business. If The Zesty Zing had a market value of £300 with £50 of cash in its till and no debts, then you would really be paying £250 for it. If it had other assets that could be sold without affecting the business, you could deduct what you might get for those too. Maybe The Zesty Zing comes with a shiny bike to get to its pitch, but you don’t need it as you’re just a block away. Deduct those too.
Let’s adjust Water Intelligence and Somero Enterprises by our EV/E ratio.
It doesn’t get any better for Water Intelligence does it? Water Intelligence is priced much higher than Somero Enterprises based on our adjusted ROCE, further adjusted by EV/E ratio. Oh dear. I’m off to buy some more Somero.
Time Travel
The final thing we need to dig into is time. Let’s take a peak at how our adjusted ROCE calculation is changing with time. We’ll leave out the additional EV/E adjustment for now.
I’ll take the growth rates of both companies and project out a future with decaying performance over time. I’ll be quite conservative, I think!
Hmmm, interesting! The figures up until 2023 are actuals, so you can see Water Intelligence has been gaining on Somero. Water Intelligence has higher organic growth in EBT than capital employed. They are likely to improve margins into the future due to the profitable nature of the franchises they are acquiring. They will also be in a position to build cash or pay down debt once franchise acquisitions slow, further improving EBT.
The future adjusted for price
Let’s now take our adjusted ROCE and adjust it once more for EV/E and see how that compares.
Firstly, my nice smooth lines from 2023 onward are unlikely to reflect reality, which is usually more bumpy but may reflect averages (given enough time). Secondly, Water Intelligence is becoming much more valuable with time. They are likely to outstrip Somero in organic growth rates, especially earnings. I’ll fade the adjusted ROCE lines so the trend direction becomes more apparent.
If Water Intelligence continues to grow faster than Somero they will eventually surpass them in value. My modelling took fairly conservative rates of growth based on history over the past 7 years. So, yes, a stock with a terrible ROCE, calculated using the standard street formula, may turn out to be a better investment over time. So be careful when you use ROCE to make investment decisions or filter stocks. You could be passing up on some great investments.
Let’s have a look at our adjusted ROCE from 2022 and 2029 side by side.
While Somero is still likely to be ahead in 2029, there is a big swing upward in Water Intelligence. A 15-fold increase. Whereas Somero managed a 2.4x increase. But it’s the rate of growth that’s impressive. Water Intelligence was less than 10% of Somero in 2022 but could grow to over half their valuation by 2029.
Water Intelligence, with it’s higher rates of organic growth and capital deployment coupled with a future ability to pay down debt and build a cash position, will grow adjusted ROCE at a far quicker pace. This is why there is a big difference in the current valuations of these businesses, even with Somero’s very attractive dividend yield.
The Final ROCE Calculation
Probable Gains
I mentioned earlier that I calculated EV for both stocks into the future. Let’s look out 5 years and compare 2028. We’ll assume a price-to-earnings multiple of 12 and work out what the share price might be. Water Intelligence will likely have a higher multiple should organic growth persist, but we’ll keep them level for now. Who knows, maybe concrete flatness standards around the world will favour big growth in Somero. That’s the thing about the future—we just don’t know!
We’ll assume no capital is distributed and it simply builds up on the books, contributing to a lower EV.
So, in fact, I have Water Intelligence ahead of Somero Enterprises, despite Somero having a far superior street ROCE. In reality, I don’t expect returns this high; the future is very uncertain. But it does tell me something about my current understanding of the value of today’s price. Both of these businesses are great investments, if you ask me.