Importance of RoE and RoCE in stock analysis

Why RoE and RoCE are important?

Introduction

Warren Buffet and Charlie Munger, who are billionaire investors, partners and part of the multinational conglomerate holding company ‘Berkshire Hathaway’ always emphasize the importance of analyzing return ratios that give an understanding about how efficiently companies are utilizing the capital available in various forms like share capital, reserves & surplus, borrowings. Let us take a look at what these ratios are and why are they important in stock analysis.

Importance of Return Ratios

What is RoE?

• Return on Equity (RoE) of a company is : ( Net Profit/Average Shareholder’s Equity) * 100
• The net profit considered in the above formula is before paying out the dividends.
• It is the ability of the company to generate profits based on the shareholder’s equity that includes both share capital and reserves & surplus.
• Reserves and surplus also include retained earnings, which is the balance in the profit and loss account after paying out the dividends.
• Retained earnings is an important part of the equity share capital. Let us understand with the help of an example.
• Consider a snapshot of the ICICI Bank annual report 2019-20 shown below. Observe how the balance in profit and loss account is included in one of the components of Balance sheet’s total reserves and surplus part.

• In banks, Tier I capital includes share capital as well as retained earnings. This can be used in longer term for both growth as well as contingency situations.

What is RoCE?

• Return on Capital Employed (RoCE) of a company is :
  (Earnings Before Interest and Tax (EBIT)/ Capital Employed)*100
• Capital Employed is:
  Common shareholder’s equity + Preferred shareholder’s equity + Short term borrowings + Long term borrowings
• The main reason for using operating profit or EBIT here is to capture the interest expense paid by the company on its debt.
• The main difference between RoE and RoCE is that RoCE focuses on the ability to generate profits based on not only shareholder’s equity but also borrowings from the market(debt).
• RoCE emphasizes on how the company is allocating its overall capital.

Importance of RoE and RoCE

• If the company decides to raise additional capital from the market and yet is able to generate healthy RoE and RoCE , it indicates that the company is prudently allocating its capital and able to generate healthy profits.
• RoCE will be very high for companies which have negligible debt. In such cases, instead of entirely relying on RoCE we should look at RoE as well for analyzing the company. Some of the examples of such high RoCE are sectors like FMCG, Information Technology, etc.
• On the flip-side, RoCE is more suitable while analyzing companies from  the capital intensive sectors like construction and aviation.
• Normally, we suggest those stocks, which have modest dividend payout ratios and higher retained earnings. These higher retained earnings help in generating greater return for shareholders.
• Also, these ratios should be compared with the company’s peers and industry average to evaluate its relative performance.
• So the best way to analyze the companies is to use both ratios in tandem so that it provides a better insight into company’s performance.