Know your market – What’s difference between ROE & RoCE?
If you’re looking to invest in Indian stock market or you’ve already invested some money into it, this post would be of some value to you and your future plans. Among various stock market terms, ROE and RoCE are the most commonly used terms.
For a trader and investor, it is extremely necessary to possess a great know how of these terms in order to become successful. The below given formulas may be able to throw some light on the difference between ROE and RoCE.
What is ROE and RoCE?
Both the terms are basically a measure of company’s profitability. It simple means, they high point how well the company employs its funds (capital). But ROCE gives a precise measure of company’s profitability than ROE. Let’s get to know how?
ROE: Return on Equity (ROE) is a measure of how much net profit company is generating for every invested Rupee of shareholders money. ROE reveals the profitability from the investor’s perspective only. High ROE does not essentially mean that the overall business is also profitable.
RoCE: Return on Capital Employed (RoCE) is a measure of how much operating profit (EBIT) company is producing for every Rupee of capital used for its operations. RoCE reveals the profitability of the overall business. High RoCE always means that the business is running in profts. But there are limits.
High ROE is a necessary tool for shareholders. But high RoCE influences a wider audience. How? When EBIT is on upper side, Government will get more tax. Lenders are assured that their loans will be paid back. Shareholders are assured of higher returns (dividend, appreciation or both).
Value of employed capital
Money (capital) is an essential thing that is used to perform various operations of a company. When this “capital is employed”, it is used to purchase fixed assets (land, building, machinery etc.). The capital is also used to pay for the expenses (vendor payments, salaries, utility bills, interest, tax etc.). This funding further gives more sales and profits.
Now when it comes to check the total profit status of a firm, relying solely on ROE is not a good way forward, but it is necessary to take RoCE into consideration.
How to ascertain if the company is employing its debt astutely? This can be performed by using the RoCE metric. If RoCE ratio is better than the average interest rate paid by the company on its debts, it is a signal of better debt utilization.
ROE and RoCE Comparison
Companies take debt to seek benefit from leverage. These are many companies, that generate more returns for its shareholders, if they take debt.
If such a company stays debt free, it produces Rs.X net profit (say). But if this company takes debt, it will generate Rs.(X+1) net profit. This is a scenario of higher profits (PAT) when debt is encompassed in the “employed capital”. High PAT means, higher ROE (better shareholder value).
But this does not mean that high ROE companies can go on taking more and more debts for the purpose of increasing ROE. There must be an equilibrium. Why? Because excessive amounts of debt will make the company defenseless and perilous.
When it comes to comparing ROE, RoCE and D/E, the purpose is to basically analyze the effect of debt on a firm’s profitability. To get a precise understanding of the effect of debt, let’s do these things:
- Learn to calculate ROE, RoCE and D/E.
- Interpret the effect of debt on company’s ROE, RoCE and D/E.
How to calculate ROE, ROCE AND D/E?
In the below example, you’ll get to know how can we calculate ROE, ROCE AND D/E. There are two firms A and B.
Return on Capital Employed (RoCE) = EBIT / Employed Capital
- RoCE = 1,505 / 44,832 = 4%(A).
- RoCE = 621 / 1,447 = 9%(B).
Return on Equity (ROE) = PAT / Equity
- ROE = 509 / 41,929 = 2%(A).
- ROE = 402 / 1,098 = 6%(B).
Debt to Equity Ratio (D/E) = Total Debt / Equity
- D/E = 2,903 / 41,929 = 07(A).
- D/E = 349 / 1,098 = 32(B).
As you can see, calculation of ROE and RoCE is direct. Most of the numbers required for the calculation are available truthful in the financial reports.
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What if ROE is high?
For business that have high ROE, it is suggested to hold their earnings (profits).
Company produces 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.
Every year the reserved earning is moved to the company’s balance sheet. The increasing retained earnings in balance sheet is known as “reserves”.
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What if RoCE is high?
High RoCE means the company is using its capital more carefully. In general, company’s RoCE must be higher than a smallest level. What is the minimum level? It is known as Cost of Capital.
If this is not the case, it means debt is harmful to the company. Such companies are doing damage to their shareholders by bringing in high debts in its capital structure.
Easy Tips
The more is the ROE and RoCE the better. But as an investor, it is advisable to get more meaning out of these numbers.
We can refer to 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 same sector. Why? Due to the nature of business of 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, minimum return expectation will be higher than 9% (say 12%). So, a profitable company will an objective to keep their 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 one which is producing ROE and RoCE above 25% p.a (15%+10%). It is also imperious 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 financially healthy company.
Conclusion
For investors, it is advisable to search for companies that increase in debt in association with similar increase in EBIT. Why?
Take example of a company which has RoCE of 18%. It has definite to avail more debt (20% more) to fund its capital procurement. To uphold the same level of RoCE, EBIT of the company must also increase by 20%.
The higher is the ROE the better. But it is also necessary to keep in mind that the difference between ROE and ROCE should not be too high. If it is a Zero Debt company, ROCE will be higher than ROE. But when debt is opted: ROCE will reduce due to “B” (debt) in denominator. ROE will increase due to increase in PAT.
But if ROCE becomes too low, in comparison to ROE, it means 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 RoC Enear to 25% means a profitable company to invest in.