Investors choose various financial metrics when it comes to analyzing a particular stock and whether it offers them a bang for their buck or not. Some choose to look at operating cash flow, while others look at dividend yields. There are also some who prefer Price-to-Earnings (P/E) multiples while others look at Price-to-Book Value (P/B) while mostly analysing banking stocks.
Some investors also prefer to look at two other financial metrics for analysing stocks. One is ROE - Return on Equity and the other being ROCE- Return on Capital Employed. Both are generally used together to gauge the operational efficiency of a company and the potential for future growth in value.
Let's first take a look at ROE. Return on Equity is what a company generates for its shareholders after paying taxes but before paying dividends. It is therefore used to determine how much surplus a company generates that either needs to be allocated to shareholders as dividend or reinvested into the business.
How can you calculate ROE?
To calculate ROE, divide the company's net profit by the shareholders' equity and multiply it by 100.
So, if a company has made a net profit of Rs. 70 crore and has a shareholder equity of Rs. 140 crore, the return on equity will be 50%. The ROE represents the firm’s ability to turn equity investments into profits. The above figure means that the company is able to generate a profit of Rs 0.50 for every Re. 1 that it invests.
A higher ROE suggests that a company is more efficient when it comes to deploying shareholder capital. A rising ROE means that a company is managing to generate greater profits without needing as much capital in proportion. On the other hand, a lower ROE would mean that a company may have some management issues and could be reinvesting earnings into unproductive assets.
However, a higher ROE may not necessarily mean that a company has been successful in generating profits internally. A company may also rely on debt to generate a higher net profit, thereby pushing the ROE higher. A company with a debt/equity ratio of 4x generates an ROE of 13% as compared to a company with a debt/equity ratio of 9x and an ROE of 23%. No prizes for guessing which one is better.
Let’s now take a look at the other metric which is Return on Capital Employed or ROCE.
As the name suggests, ROCE measures the return on capital employed to reflect upon how efficiently the company is utilizing its capital to generate profits.
How can you calculate ROCE?
ROCE considers EBIT (Earnings before Interest, Tax) as the numerator while capital employed acts as the denominator.
How do you calculate the Capital Employed? That can be done by subtracting the total assets of the company with its current liabilities and adding long-term debts of the company.
Therefore, ROCE= EBIT / Capital Employed
The higher the value of the ROCE, the better are the chances of obtaining a profit.
Let us consider a company that has an EBIT of Rs. 10 crore. It has employed capital worth Rs. 34 crore. On dividing the two, we get a ROCE of 29.4%.
So, why is ROCE important? ROCE considers other stakeholders like lenders and debt holders, unlike ROE. It is a better measure when you are evaluating companies that have a longer gestation period like power, infrastructure, and telecom.
To conclude, can you choose one over the other? Ideally, the best way to analyse a company is by taking a look at both the numbers. When a company's ROCE is greater than ROE, it means that the company is utilising its debt well to reduce its overall cost of capital. However, it may also mean that debt holders are being rewarded more handsomely, as compared to equity holders.
In the words of the legendary Warren Buffett, both ROE and ROCE should be greater than 20%. The closer they are to each other, the better. A large divergence between the two, on either side, and you may have second thoughts about the company and whether you should invest in it or not.
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