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

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

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 assessed. 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

Investing Articles

Should I still be cautious about Rolls-Royce shares?

Rolls-Royce shares are flying. But is now the time for this Fool to open a position? Here, he explains why…

Read more »

Group of young friends toasting each other with beers in a pub
Investing Articles

Is the Diageo share price coiled to rebound?

Christopher Ruane explains why he remains bullish about the long-term outlook for the Diageo share price and would happily invest…

Read more »

Young Asian woman holding a cup of takeaway coffee and folders containing paperwork, on her way into the office
Investing Articles

How I could make a 10% yield for high passive income a reality

Jon Smith explains how he can target high passive income from top-yielding stocks, including one specific example he'd consider.

Read more »

Investing Articles

I’d buy 1,784 shares of this FTSE 100 stock to target £350 of monthly passive income

Muhammad Cheema takes a look at how British American Tobacco shares, with a dividend yield of 10.1%, can generate a…

Read more »

White female supervisor working at an oil rig
Investing Articles

1 ex-FTSE 100 stock that I think will get promoted soon

Jon Smith flags up an energy stock that used to be in the FTSE 100 and currently has strong momentum…

Read more »

Shot of a young Black woman doing some paperwork in a modern office
Investing Articles

With an 8% dividend yield, I think this undervalued FTSE stock is a no-brainer buy

With an impressive yield and good track record of payments, Mark David Hartley is considering adding this promising FTSE share…

Read more »

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

£9,500 in savings? Here’s how I’d try to turn that into £1,809 a month of passive income

Investing a relatively small amount into high-yielding stocks and reinvesting the dividends paid can generate significant passive income over time.

Read more »

Businesswoman analyses profitability of working company with digital virtual screen
Investing Articles

Dividend star Legal & General’s share price is still marked down, so should I buy more?

Legal & General’s share price looks very undervalued against its peers. But it pays an 8%+ dividend yield, and has…

Read more »