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.
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.