Profitability ratios are financial metrics used by various stakeholders and investors while investing in a company. ROE and ROCE are profitability ratios often used together to evaluate the complete financial performance of a company. Let us clearly understand what ROE and ROCE are.
How can you choose a company to invest in? So let's begin.
What is ROE?
Return on equity (ROE) is a commonly used metric for comparing companies. It's relatively straightforward and is calculated by dividing the Net income by total equity. It is more significant for investors since it helps them judge how efficiently the company utilises its invested money. The higher the ratio, the better the performance of the company. The formula used to calculate ROE is:
ROE = Net profit of the company
Total No. of shares
What is ROCE?
Return on capital employed (ROCE) is calculated by dividing the operating profit before taxes by the capital employed. Capital employed is the sum of fixed assets (factories, machines, buildings, etc.) and working capital (inventories, accounts receivable, etc.).It is an essential measure for investors that gives them an insight into the company’s capabilities before making an investment decision.
It is an essential measure for investors that gives them an insight into the company’s capabilities before making an investment decision. The formula used to calculate ROCE is:
ROCE = EBIT/Capital Employed
The higher the value of the ROCE ratio, the better the chances of profits. Investors must look for companies with higher ROCE value and compare them with the various other companies, before arriving at an investment decision.
The key differences between ROE and ROCE
ROE represents your return on your residual equity capital. ROE only measures the net return on equity of your company. However, ROCE is calculated taking all shareholders into account, including equity and debt.
A ROCE greater than the ROE indicates that the overall capital is being serviced at a higher rate than the equity shareholders. A school of thought holds that if the ROCE is greater than the ROE, debt holders are disadvantaged at the expense of equity holders. It may be true theoretically, but it is not true practically. This is because your obligation to debt holders is limited and known as the sum of interest and principal. Increases in ROCE are a benefit to equity holders only.
As another benefit, higher ROCE will benefit equity shareholders. ROCE allows a company to borrow and raise capital at attractive terms compared to its peers. As a result, it can lower its overall cost of capital and equity. The valuation of the company will be improved. It’s important to remember that the ROCE has a greater impact on your overall cost of funds than the ROE.
The ROCE is a more accurate measure of capital utilisation efficiency. It is essentially a mirror image of the long-term assets of the company since capital here consists of long-term equity and debt. So this also becomes a measure of how efficiently your assets are being used. The return on equity (ROE), on the other hand, is primarily concerned with equity holders and often neglects return on assets, which is very important.
Is it then that a company with a ROCE that is substantially higher than its ROE is a good case? Perhaps not! An example would be a company with an ROE of 16 percent and a ROCE of 22 percent. How should you interpret that difference? Due to the ROE being a measure after the financial cost appropriation, this shows that the company has been borrowing at excessive rates. This means that debt is affecting shareholder returns and has negative implications.
This comparison of ROE and ROCE is used extensively by Warren Buffett. Buffett prefers companies with ROE and ROCE that are very close to one another. Good companies should have a gap of no more than 100-200 basis points. As a result, both the long-term stakeholders of the company in the form of shareholders and lenders would be catered for. Furthermore, it will ensure that no stakeholder is compromised at the expense of another.
The more the ROCE the better. But as an investor, it is advisable to get more meaning out of these numbers.
We can refer to a few thumb rules to decipher the puzzle:
Same Sector: It will not be operative to compare stocks of various sectors. A better option is to compare stocks of the same sector. Why? Due to the nature of business, each sector is unique. Some business lines are inherently more profitable than others. Hence ROE and ROCE of two separate business lines cannot be compared.
ROE: In India, a good debt-based mutual fund can harvest a return of 9% per annum. So if one decides to invest in equity, the minimum return expectation will be higher than 9% (say 12%). So, a profitable company will have an objective to keep its ROE levels well above it (like 15%+).
ROCE: In India, corporate can get debt at an interest rate of 8% p.a. So, a profitable company will try to keep their ROCE levels quite above it (like 10%+).
Ideal Company: In India, a perfect company will be producing ROE and RoCE above 25% p.a (15%+10%). It is also imperative to note that ROE, ROCE, and D/E must remain in balance. Hence ROE, ROCE above 25%, and D/E close to one (1) is a perfect sign of a financially healthy company.
For investors, it is advisable to search for companies that increase in debt in association with a similar increase in EBIT. Why?
The higher the ROE the better. But it is also necessary to keep in mind that the difference between ROE and ROCE should not be reasonable. If it is a Zero Debt company, ROCE will be higher than ROE. But when debt has been opted: ROCE will reduce.. ROE will increase due to an increase in PAT.
But if ROCE becomes too low, in comparison to ROE, it means a surge in EBIT is not taking place properly. Too low ROCE is also not beneficial for the shareholders. Why? Because ultimately ROE will get affected.
In that case, keep in mind that ROE and ROCE near 25% mean a profitable company to invest in.