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ROE and ROCE
When investing in companies, we invest with an optimism that they will do well in future.
But how can we know that the company is giving decent returns.
Is Net Profit number a good number to depend upon?
No! Because, Net Profit is the profit that the company has made.
This need not be the profit that the investor will be making if invested in the company.
There are several methods of finding / evaluating financials of a company.
ROE and ROCE are two such tools that help evaluate financial performance of a company from the perspective of what an investor would get.
Return on equity (ROE)
Return on equity = Net income / Shareholders equity
Net Income is comprised of what is earned over the period of a year, minus all costs and expenses.
It includes payouts made to preferred stockholders but not dividends paid to common stockholders.
Also Shareholders' equity value excludes preferred stock shares.
A higher ROE ratio means that the company is using its investors' money more efficiently to enhance the company's performance and allow it to grow and expand in order to generate increasing profits.
This formula allows investors and analysts an alternative measure of the company's profitability and calculates the efficiency with which a company generates profit using the funds that shareholders have invested.
Return on Capital Employed (ROCE)
ROCE = Earnings before interest and taxes (EBIT) / Capital Employed
Here, “Capital Employed” as shown in the denominator is the sum of shareholders' equity and debt liabilities; it can be simplified as (Total Assets – Current Liabilities).
ROE considers profits generated on shareholders' equity, but ROCE is the primary measure of how efficiently a company utilizes all available capital to generate additional profits.
Some important points to consider
1. Smaller equity base results in higher percentage earnings for the shareholders.
2. A company may operate with a very healthy ROCE but it may not add much value to a shareholder if most of the income generated is used up in servicing the company’s debt (i.e. interest charges).
3. More debt may be good or bad – If a company can generate a return higher than the interest charges which it pays on servicing its debt, then taking higher amounts of debt will increase shareholder profitability (in other words, in such a situation shareholders will be able to earn profit for themselves using debt or loaned money). So debt is not always bad. However, in case of economic slowdowns or business setbacks, companies with higher levels of debt often cannot maintain higher profitability and interest charges often overtake profitability.
Good companies give a positive change in return on capital ratios.
Companies cannot always keep on improving their ROCE all the time.
If other factors are good (particular fair price valuation), even an above average ROCE is sufficient in some cases.
Rule #38: Invest in companies that have good ROE and ROCE (compared to its sectoral peers)
1. Can ROE and ROCE numbers between companies in the same sector be compared? Compare and check the ROE numbers of FMCG companies.
2. Check the ROE and ROCE of the companies in which you have invested. What are the conclusions you draw from them.
- Introduction to Financial Ratios used in Stock Analysis
- PE Ratio
- Nifty and Sensex PE
- Book Value
- Operating Profit Margin
- Earnings Per Share
- Stock Current Market Price and Valuations