Low-margin businesses can also be wealth generators. Here's how

Investors often associate high margins with long-term sustainability for companies. They believe higher margins provide a safety net to tackle challenging business environments. While this notion holds merit, solely relying on operating margin may cause you to overlook promising wealth-creating opportunities.

This is where the return on capital employed (ROCE) steps in as a crucial metric.

What is ROCE, and how does it work?

ROCE measures how effectively a company utilises its capital to generate profits.

It's calculated by dividing earnings before interest and tax (EBIT) by total capital employed.

The ratio can be further broken down into two components.

ROCE = (EBIT/Revenue) * (Revenue/Total capital employed)

Simply put, ROCE reflects both the operating profit margin and capital employed turnover ratio.

The capital employed turnover ratio measures the revenue generated per unit of capital employed. Therefore, even if a company maintains a low operating profit margin, it can still achieve high returns on capital by increasing sales volume.

Several companies have demonstrated this strategy effectively over the years.

Take Avenue Supermarts , for instance. It operates the 'DMart' supermarket chain. The company leverages its scale to drive bargains with its suppliers. This, in turn, allows it to sell groceries at marked-down prices and attract massive footfall to its stores. Thus, despite a relatively low operating profit margin, DMart's high capital employed turnover allows it to generate high ROCE.

Similarly, Dixon Technologies , an electronic manufacturing services provider, operates on a wafer-thin operating profit margin but compensates with high volumes. This has resulted in Dixon generating an average ROCE of nearly 30 per cent over five years.

Another example is APL Apollo Tubes , a structural steel tube manufacturer. As the company accounts for nearly 2 per cent of Indian steel consumption, it can procure raw materials at a relatively low cost. Furthermore, the rising demand for structural steel tubes has propelled its revenue growth in the last five years. This has translated into a robust ROCE for the company.

What's in it for you?

Understanding the relationship between operating profit margin, capital employed turnover and ROCE is crucial. While low margins may seem concerning, they can be advantageous if a company can leverage its strength to enhance capital employed turnover. However, it's essential to consider industry dynamics and other factors alongside these metrics when making investment decisions.

Also read: What is return on equity (ROE)?

This article was originally published on February 02, 2024.