Lemonade Parade: The ROCE of Lemonade Stands
How much can you trust ROCE?
ROCE may be misleading you as to which stocks are actually winners. ROCE, as calculated by “The Street," does not tell the complete story; don’t trust it! Let’s dig into the ROCE of two stocks I’m invested in to see which of them is a better business. But first, lessons!
Hold on, What’s ROCE Again?
Operating profit is the money you have left to buy sweets after closing up your lemonade stand for the day. It’s the money a business makes after paying all expenses, cash and non-cash, but before paying interest and taxes.
Capital Employed is calculated as:
It’s the lemon press plus all those lemons minus what you owe Bob Sprout, the greengrocer, next week. It’s a fancy way of saying what a business has tied up or is owed minus anything it owes in the near term. Basically, how efficient you are at generating profits with your lemon press and lemons.
Let’s Get Down To It
Water Intelligence vs Somero Enterprises
Which is the better business to invest in? We’ll compare the year-end for 2022. Starting with ROCE, as the folks on “The Street” would see it:
Figures taken from SimplyWall.St (March 2023)
Somero Enterprises is by far the better business! Water Intelligence probably isn’t worth bothering with, right? But I own both, so clearly, I don’t think so. Let’s unravel this mystery a little more, starting with cash.
So What About Cash?
Your uncle just lent you £100 to open up Lemonade Parade II. Once you sell some more lemonade today, you’ll be able to pay Bob Sprout with spare change left over to pay your uncle a bit of interest on that £100. You’re not quite ready to go big time yet, Lemonade Parade II can wait a bit, so the £100 is just sitting there. It’s not really making you any money.
Let’s deduct that surplus cash from the capital employed to see what the ROCE looks like for both of these businesses. We’ll also deduct interest from EBIT, leaving EBT. You’ve got to pay your uncle some interest, remember? Some people like to leave interest out, but unlike shareholders, debtors require payment. Enterprise value does come into the equation in part II, which helps explain adding the interest back in.
All the cash on the balance sheets of both businesses is surplus. There’s a slight quirk with Water Intelligence in that their current liabilities include deferred payments for franchises. You can ask me about that some other time if you’re interested.
ROCE After Deducting Surplus Cash and Adding Back Net Interest
Holy smokes, the gap widens! Somero Enterprises is the clear winner here. They really know how to squeeze the most out of those lemons. Surely you should go out and buy some shares? Hold!
Is There Any Goodwill?
So Somero Enterprises looks truly spectacular, but there’s an elephant in the room: goodwill. You’ve taken your uncle’s £100 and bought another lemonade stand with it. It comes with a nice press, worth about £20, and £10 worth of lemons. Wait, why’d you pay £100 for it? It’s only worth £30! Oh, it’s on the corner of the Sweat Sanctuary gym. Those guys always need cold lemonade. That was a smart investment; you’ll make tons.
Like you, Water Intelligence has been acquiring franchises and a few other businesses for more than they appear to be worth. As the balance sheet needs to, erm, balance, we have to account for that difference—enter goodwill! This is an asset included in total assets and, therefore, capital employed. Buying Lemonade Parade II left you with £70 of goodwill. That £70 is included in your ROCE and it’s making you look much worse than when Lemonade Parade II was independent. Is that a fair comparison?
Unlike you, Somero Enterprises has built its business organically and isn’t carrying much goodwill from acquisitions. It looks a bit like Lemonade Parade II before you bought it, with only £30 of assets on the balance sheet and a much better ROCE. If someone were to buy Somero for its market value, they would end up with about $137 million of goodwill on their balance sheet. By simply acquiring this business for its enterprise value, you would decimate the ROCE, even though nothing has changed! So, it’s a bit unfair on Water Intelligence. I’ll deduct goodwill from their capital employed to see what that looks like.
That looks a little better. It was goodwill that was distorting the ROCE of Water Intelligence. But this is just a single year and could be a one-off high or low for either business. Let’s look at the past 6 years to see what average ROCE looks like using our new formula.
Looking at how ROCE is changing over time can help smooth out one-off impacts on EBT that you may not have spotted (impairments, asset sales, acquisition costs, etc.) Sometimes, businesses aren’t clear at pointing these out.
ROCE can change. Notice the improvement in the ROCE of Water Intelligence as they add stores with PBT margins of 20% to 25%. These businesses are asset light, so we can probably expect this to continue its upward trajectory, especially as they improve margins in their international business.
Somero Enterprises had a blip from the 2018 wobbles that Water Intelligence managed to avoid. Then they benefited from the post-COVID release of held-up projects. So keep an eye on how ROCE is changing and why. A single year may not tell you the real story. Maybe the Sweat Sanctuary is now a prime location for a vegan bakery—time to sell that lemonade stand?
Even now, Somero looks like the better play on ROCE calculations alone, but there are other things to consider, such as the price you pay for ROCE and how to discount differences in potential growth. What if you opened a lemonade stand in the northernmost remote countryside of freezing Finland? What if Water Intelligence is deploying more additional capital than Somero Enterprises and opening more lemonade stands? A business with a high ROCE that isn’t deploying any more capital may not be a good investment. Shouldn’t we factor that in? What if Water Intelligence has greater organic growth than Somero Enterprises? Perhaps they’ve discovered the secret sauce of thirst quenching lemonade? Perhaps margins are expected to improve as you’ve struck a new deal with Bob Sprout for lemons? These are very important parts of any valuation, which we’ll explore in the next installment!