Difference Between Return on Equity & Return on Capital Employed
ROE and ROCE are the financial metrics which act as a valuable tools for measuring a company’s operational efficiency and potential for attaining future growth in value. In this article, we will compare Return on Equity(ROE) Vs Return on Capital Employed(ROCE) in detail.
Return on Equity (ROE)
- Return on Equity (ROE) is a key aspect in fundamental analysis. It is also very important to look at while evaluating a company.
- ROE is a measure of a company’s financial performance. It indicates the relationship between a company’s profit and the equity shareholder’s return. It shows how much profit a company generates with the money (capital) shareholders have invested.
- ROE is also and indicator of how effective management is at using equity financing to fund operations and grow the company.
- The higher the ROE, the more efficient the company’s operations are at making use of those funds. Since every industry has different levels of investors and income, we can not use ROE to compare companies outside of their industries very effectively.
Return on Capital Employed (ROCE)
- Return On Capital Employed (ROCE) is a financial ratio. It determines a company’s profitability and the efficiency with which the capital is applied. A higher ROCE indicates a more cost-effective use of capital. It is also called as Return On Total Capital (ROTC).
- So, we can say, ROCE is a profitability ratio that measures how efficiently a company can generate profits from its capital employed by comparing net operating profit to capital employed.
- ROCE works especially well when comparing the performance of companies in capital-intensive sectors, such as utilities and telecoms, because unlike other fundamentals, ROCE considers debt and other liabilities as well.
- Thus , ROCE provides a better indication of financial performance for companies with significant debt.
ROE Vs ROCE
A viewer had asked us a question that, if a company doesn’t have any debt, neither long term nor short term, then the ROE and ROCE numbers should both be same. Logically that is true, but there are few differences there.
1. Difference by Formula :
- ROE = Net Income (Net Profit) ÷ Shareholders Equity
- Where, Net Income is the actually money earned by the company and is taken of the last 12 months. Here, Shareholders Equity includes Equity Capital, Reserves & Surplus and Retained Earnings.
- ROCE = Earnings Before Interest & Taxes (EBIT) ÷ Total Capital Employed
- Where, EBIT is Operating Profit and Total Capital Employed is the sum of Total Equity (equity share capital, reserves and & surplus and retained earnings) and Total Debt.
- Hence, logically ROCE and ROE would be similar if the company did not have any debt. But technically, even if the company doesn’t have to pay any interest on the debts but it still has to pay the taxes. Therefore, ROCE and ROE values would be different.
2. Other Key Points of Comparison ROE Vs ROCE :
- ROE only considers the net return on the equity of the company (net return to only shareholders equity). While ROCE considers the return to all stakeholders in the company including equity and debt (Long-term Debt).
- When the ROCE is greater than the ROE, it means that the overall capital is being serviced at a higher return than the equity shareholders. A higher ROCE only leaves a greater surplus for the equity shareholders.
- Equity shareholders will also benefit from a higher ROCE in another way. When a company has a high ROCE, the company is able to raise debt and equity at attractive terms compared to the peer group. That means its cost of equity and its cost of capital overall will come down. This will help to improve the valuations of the company. Remember, the ROCE makes a much bigger difference to company’s overall cost of funds compared to its ROE.
- ROCE is a better indicator of the efficiency of utilization of capital. Since capital here becomes the sum of equity and long term debt, it is virtually a mirror image of the long term assets of the company. In other words, this also becomes a measure of the efficiency of the usage of your assets. ROE, on the other hand, is purely focused on equity shareholders and tends to gloss over the very important aspect of return on assets.
- Warren Buffett’s view on ROE vs ROCE : Buffett’s view is that he would prefer companies that have ROE and ROCE that are very close to each other. Ideally, for a good company, the gap should not be more than 100-200 basis points. This will imply that both the long term stake holders of the company in the form of shareholders and lenders are properly taken care of. It will also mean that any set of stakeholder is not being compromised at the cost of other.
3. Comparing ROE Vs ROCE Numbers
- While comparing the ROCE and ROE numbers of any company one should always first look at the industry in which the company is involved.
- If the company is involved in a capital-intensive industry, like utilities, infrastructure, telecom, and even baking to certain extent (as they too borrow money from others), then one should focus more on the ROCE number of that company. This is so as it is major task to service the debt for such companies.
- Also, while using ROCE and ROE for analysing companies, it is important to note that we should choose the companies of the same sector.
- For Example, you cannot compare FMCG companies with Steel companies. If you want to compare HUL you can compare it with companies of the same sector, like Godrej Consumers Products. We can not compare HUL with Tata Steel.