Stock analysts must understand the benefits of ROE vs ROCE comparison.
Comparing a stock like this, gives a lot of insight to investors about the company’s fundamentals.
What is ROE? Return on Equity.
What is ROCE? Return on Capital Employed.
Before we get into the formula for ROE and ROCE, lets understand the meaning of following terms:
- Return (in ROE): PAT (Net Profit).
- Return (in ROCE): EBIT (Earning Before Interest & Tax).
- Equity (ROE): Shareholders Capital (Equity Capital + Reserves).
- Capital Employed (ROCE): Total Capital (Total Asset – Current Liability).
What is shown in above formula?
ROE highlights the returns of only the shareholders.
ROCE encompasses returns of all stakeholders (shareholders, lenders, and government). How?
Higher ROCE means higher returns for the following:
- Government: Higher tax collection.
- Lenders: Assured principal plus interest collection.
- Shareholders: More dividend & capital appreciation.
Which is more relevant for investors, ROE or ROCE? Both are good.
If we are seeing stocks only from a perspective of a shareholder, ROE is good enough.
But it is better to see stocks from perspective of a business man.
In this context ROCE gives a much better realisations about the business fundamentals of the company.
In fact, comparison of ROE Vs ROCE clears a lot of cloud about the profitability of business in consideration.
Knowledge about ROE and ROCE in isolation is not as effective as result obtained out of comparison between ROE vs ROCE.
Why to bother about profitability?
Higher is the profitability of the business, better will be its long term prospects.
In fact, the study of ROE and ROCE of a stock is done with the objective to develop an informed opinion about the companies profitability.
How ROE Vs ROCE Comparison is beneficial?
Generally speaking, we believe that high debt is bad, right?
But there are some companies for whom debt is not bad.
These are those companies, which generates more returns for its shareholders, if they take debt.
What does it mean?
If such a company remains debt free, it generates Rs.X net profit (say).
But if this company takes debt, it will generate Rs.(X+1) net profit.
Yes, it is possible.
These are unique companies which enjoy the advantage of “leveraging”.
Why I am talking about leveraging here?
Because a comparison between ROE Vs ROCE will highlight such unique companies.
These are such companies which are inherently so profitable, that debt gives them further leverage to generate higher profits (PAT).
High PAT means, higher ROE (more benefit for shareholders).
Hence, shareholders must always compare ROE and ROCE of a stock.
What to compare in ROE and ROCE?
ROE > ROCEROE shall be more than ROCE
How this makes the difference?
Higher ROE compared to ROCE means:
- Profitability of company is good.
- Shareholders returns are enhances due to debt.
Here I would like to point out that such companies are rare, whose ROE is higher than ROCE.
ROE Vs ROCE of few companies that I have evaluated are as below:
These are such companies which are considered reasonably profitable in Indian context:
Out of the list of above 8 companies, you can see that only the following show ROE > ROCE.
How to Calculate ROE and ROCE?
To calculate ROE and ROCE, we need to pull following financial data from Balance Sheet and P&L Accounts of companies:
Capital Employed = Total Asset – Current Liability.
EBIT = EBITDA – D&A
ROCE = EBIT / Capital Employed.
ROE = PAT / Net Worth
Example of Calculation:
What to remember about ROE Vs ROCE?
…Who is being caterd to?...
ROE is a financial ratio used to measure how much profit a company generates for its shareholders.
ROCE is a financial ratio used to measure if the company is able to generate sufficient returns for all its stakeholders.
…What it means when ROE is very high?…
For companies whose ROE is very high (like HUL, 85%), they should better retain their earnings.
What does it mean?
Company generates net profit (PAT). A part of PAT is paid as dividends to shareholders.
The balance what remains is called “retained earnings”.
Retained earnings are invested back into the business.
For companies whose ROE is as high as HUL, they can service shareholders better by reinvesting their profits back to business (instead of paying high dividends).
This way they can ensure faster capital appreciation for their shareholders.
…What it means when ROCE is higher than ROE?…
Frankly speaking there is no easy answer to this puzzle.
But lets attempt to arrive at a logical conclusion.
How companies generate capital to do business?
- Equity Route.
- Debt Route.
For an example company XYZ, suppose debt is zero.
As debt is zero, Interest related expense will also be zero.
What will be its capital employed?
Employed Capital = Equity + Debt = Equity + Zero = Equity.
In this case what will be XYZ’s ROE and ROCE
As EBIT is always greater than PAT, in this example, ROCE will be more than ROE.
ROCE_1 > ROE_1
What does it mean? For a debt free company, ROCE will be always be more than ROE.
Now suppose XYZ takes some debt from bank.
Because of the use of debt (B), what will be the likely changes in ROE and ROCE of XYZ?
To get more clarity, lets compare ROE of Case_1 with ROE of Case_2
It is interesting to note what is happening here.
As XYZ has taken debt, it is leading to following 2 effects:
- Positive Effect: EBIT is increasing.
- Negative Effect: Expense has increased in form of interest.
#Condition 1: EBIT Increase equal to interest expense.
ROCE_2 < ROCE_1
ROE_2 = ROE_1
Net effect of availing debt on companies profitability is zero.
Such debt financing is not beneficial for shareholders.
#Condition 2: EBIT Increase more than interest expense.
ROCE_2 < ROCE_1
ROE_2 > ROE_1
Because of debt, company’s ROE has increased.
Such debt financing is most beneficial for shareholders.
#Condition 3: EBIT Increase less than interest expense.
ROCE_2 < ROCE_1
ROE_2 < ROE_1
Because of debt, company’s ROE has decreased.
Such debt financing is detrimental for the shareholders.
Taking clue from the above #condition3, we can arrive at a very important conclusion.
As an investor, we must be in look-out for such companies whose ROE is more than ROCE.
The higher is the ROE the better.
But it is also essential to note that the difference between ROE and ROCE should not be too high. Why?
To understand this we have to relook at the below formula:
In case of Zero Debt ROCE > ROE.
But when debt is availed:
- ROCE will decrease (due to B in denominator).
- ROE will increase (due to increase in EBIT (c) )
But if ROCE falls too low, compared to ROE, it means increase in EBIT (compared to B) is not enough.
Low ROCE means, interest (on debt) payback may be in danger.
Such a company must try to lower its debt burden.
How much debt must be lowered? Till ROE and ROCE comes reasonably close.