New investors can find market jargon overwhelming and confusing, which can lead to negligence and bad choices.
Two such words are ROE and ROCE and they are often used interchangeably. Several sources deem one aspect more important for investors than the other. This article seeks to decode these concepts with their definitions and formulas.
Return on Equity (ROE)
ROE stands for Return on Equity, which shows how much a company has earned on the capital it generated from equities alone.
The formula for calculating ROE is:
ROE = net profits/total equity
Share market investors want to know how a company uses the money they invest. When an investor buys a share, they become a shareholder of the company. The company then utilizes the investor’s investments in its business. However, if the utilization is over-powering the investment and not churning returns, the share does not become a good investment. It is standard to assume that losses do not define good companies.
However, there is another concept for measuring returns more concretely. This is ROCE or Return on Capital Employed.
Return on Capital Employed
ROCE is a measure of the returns a company has provided from its capital. This also includes long-term surplus and debt assets. While ROE does not consider other stakeholders like lenders and bondholders, ROCE gives the investor a clear idea of what the company has until now and its overall performance.
However, ROCE too does not factor in short-term profits and bonds that can be used in business activities.
The Return on Capital Employed formula is:
ROCE = earnings before interest and taxes/capital employed
Let us dive deeper into the comparison between ROCE and ROE.
Difference between ROE and ROCE
|Considers performance on equity capital||Considers overall performance|
|Shows how efficiently the company utilizes its capital||Shows how effectively equity capital is being used|
|Primarily for company, also useful for investors||Only for equity investors|
|A high ROCE denotes the company and debt shareholders are in profits. In this case, if the ROE is low, it indicates that the company’s equity investments are not paying off.||A high ROE shows equity shareholders are profitable. In this case, if the ROCE is low, the company is under severe debt. This can later hamper its growth and equities.|
Should you look at ROE or ROCE?
Now that you have seen the comparison, you may wonder which is more suitable to assess a company – ROE or ROCE?
Lenders or bond investors find it more sensible to consider the ROCE. However, from a share investor’s perspective, both ROE and ROCE are important.
When a company goes bankrupt or decides to shut shop, it first pays off its debtors. An investor should know how much the company profits from its debt and equity. This helps them understand:
- The chances of the company sustaining the business.
- How likely are they to get paid when the chances are nil.
ROCE helps understand the overall profitability of a company. Later, the company will also use the profits to further expand its business. Investors must be familiar with ROCE when investing.
A high ROE with a low ROCE denotes that a company is likely to succumb to debt. Conversely, a company with a low ROE and a high ROCE indicates that it has no value for equity investors. As an investor, it is better to go for companies where the ROE and ROCE are not dramatically contrasting.
Frequently Asked Questions
What is a limitation of a company’s ROCE?
ROCE factors in the EBIT, and not the real profit, which can often be misleading if the company operates in a high-tax paying industry. The ROCE alone can’t help understand whether the debt assets and the equity assets are separately justified or not.
Does asset depreciation factor in a company’s ROCE?
Yes, it does. The ROCE metric is never favorable to judge old companies.
What are some drawbacks of ROE?
ROE doesn’t factor in intangible assets of a company such as its patents or goodwill that can have a long-lasting effect on the market. In the case of share buybacks, the ROE shoots up, which isn’t a realistic measure of the company’s risk in business.
What should you pay more attention to?
In case the ROCE and ROE have wildly different figures, one should look at the reasons causing the difference. If the ROCE is high it could be because the equity capital isn’t being properly utilized, however, the company can run profitably. If the ROE is high, the debt assets could be weighing over the equity ones. A look at the other parameters including PAT, Earnings per Share, Operational Capital, etc. would reveal the real picture behind the imbalance.