Want to retire early? Focus on this figure

Paul Summers outlines why a company’s ability to grow from the capital it invests can be more important than its valuation.

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

A calculator, a sheet of numbers and a pen

CC0 Public Domain

Unless you’re of an entrepreneurial bent or earn a footballer’s salary, spending less and saving more is vital if you dream of retiring early. The earlier in your life you can cultivate this habit, the better.

That said, cutting back and throwing what cash remains at the end of each month into a tax-efficient stocks and shares ISA will only go so far. If you really want to quit the rat race early, you’re going to need your investments to seriously perform over a long period of time. Here’s one way of finding companies that might do just that.

A measure of quality

Thanks to its ability to concisely indicate a company’s profitability and general health, return on capital employed (ROCE) is arguably one of the most important metrics to look at when scrutinising a prospective investment. What’s more, you don’t need a degree in finance to calculate it.

First, get hold of a company’s latest set of results and find the profit figure — otherwise known as earnings before interest and tax (EBIT). This is the ‘return’ part of the equation. Then find the company’s current liabilities and subtract these from its total assets. What remains is the ‘capital employed’. Now divide the first number by the second. The result is a company’s ROCE for that period. So, if Company X generates £50m of profits from capital of £200m, the ROCE is 25% (50/200 x 100).  

Companies with high ROCE (like the example above) are those that require relatively little investment to generate profits. As a result, these businesses tend to finance their own growth, reducing the need to carry debt. If they can compound returns of 25% or more over many years, the results can be life-changing for their investors, regardless of how much they paid for the shares in the first place. 

Some companies, by their very nature, score low on ROCE. Utilities, for example, require huge levels of capital to grow only a small amount. National Grid and SSE achieved ROCE figures of 8%  and 5.3% respectively in 2016. Banks are also notoriously capital-intensive with giants like Lloyds and HSBC having achieved pitifully low returns for many years. While this doesn’t automatically make these companies bad investments, their inability to grow at a fast pace means they’re unlikely to bring your retirement date forward.  

Now for something completely different

Contrast this with companies like retailer JD Sports and property portal Rightmove, both of which have managed to generate superb returns on a consistent basis. With ROCE averaging around 25% over the last five years, shares in the former have nine-bagged since February 2012. Continuous reinvestment has also allowed the latter to grow rapidly and become the go-to destination for house buyers. Today, shares in Rightmove exchange hands for over eight times their price in 2007. That’s despite rarely straying from a relatively high valuation. This highlights how fixating on a company’s price-to-earnings (P/E) ratio rather than its ability to reinvest and compound returns can actually be detrimental to your wealth. Sometimes, you really do get what you pay for. 

So, before making your next share purchase, take a look at how the company fares on this measure. Fill your portfolio with businesses that generate high margins from relatively little investment and your dreams of early retirement might be realised sooner than you think. 

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be considered so you should consider taking independent financial advice.

Paul Summers has no position in any shares mentioned. The Motley Fool UK has recommended HSBC Holdings and Rightmove. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

More on Investing Articles

Shot of an young Indian businesswoman sitting alone in the office at night and using a digital tablet
Investing Articles

How I’d invest £290 a month in UK shares for a passive income that beats the State Pension

UK shares can offer a lucrative path for passive income. Our writer considers a plan to double his State Pension.

Read more »

Middle-aged white man wearing glasses, staring into space over the top of his laptop in a coffee shop
Investing Articles

3 of the best shares to buy now with £2,000

I reckon the best shares to buy now have strong growth in earnings and recent good news flow, such as…

Read more »

Young female analyst working at her desk in the office
Investing Articles

How I’m aiming for £500 a month in income from dividend stocks 

Here's my three-step plan for achieving a growing income from dividend stocks and three companies I'd use to help execute…

Read more »

Warren Buffett at a Berkshire Hathaway AGM
Investing Articles

UK shares are cheap! So why is Warren Buffett ignoring them and should you too?

Many British shares are trading cheaply and pay dividends. This is normally the hunting ground for Warren Buffett, yet he's…

Read more »

Passive income text with pin graph chart on business table
Investing Articles

How I’ve increased my passive income by 600%

Finding the right opportunities can bring spectacular results. Here’s how our author has managed to increase his monthly passive income…

Read more »

Blue NIO sports car in Oslo showroom
Investing Articles

Could lithium shares make my Stocks and Shares ISA a goldmine?

Our writer is considering buying lithium shares for his Stocks and Shares ISA. Here, he outlines the decision process he…

Read more »

British Pennies on a Pound Note
Investing Articles

Is now a great time to start buying penny shares?

Are stock markets set for a rebound? If they are, there are plenty of penny shares around that might be…

Read more »

pensive bearded business man sitting on chair looking out of the window
Investing Articles

Can the Lloyds dividend survive a recession?

The Lloyds dividend has been growing strongly. But its history is more alarming. Christopher Ruane explains why he sold his…

Read more »