ROE vs ROCE: The Difference
A company’s profitability ratios are financial metrics used by a variety of stakeholders and investors to gauge the company’s profitability. ROE and ROCE are both profitability ratios used to measure a company’s performance on a comprehensive basis. ROE and ROCE are metrics used to measure the efficiency of a company’s operations and its growth potential.
As a way of expressing the ability of the company to generate returns on its shareholders’ investments (equity), the return on equity is calculated. A company’s return on capital employed, however, indicates its efficiency and profitability.
What is Return Of Equality(ROE)?
The return on equity (ROE) is one of the key aspects of fundamental analysis. When evaluating a company, it is also very important to consider this aspect.
A company’s ROE is a measurement of its financial performance. The ratio indicates how the profits of a company are related to equity shareholder returns. With capital invested by shareholders, it shows how much profit a company is able to generate. An organization’s return on equity (ROE) is also a measure of how well it uses equity financing to fund operations. The higher the ROE, the more effectively the company utilizes its funds. ROE cannot be used very effectively to compare companies outside of their industries since every industry has different levels of investors and income.
What is Return on Capital Employed (ROCE)?
The Return on Capital Employed (ROCE) ratio measures a business’ financial performance. An organization’s profitability is determined by the efficiency with which its capital is deployed. An increase in ROCE indicates more efficient capital allocation. It may also be known as Return On Total Capital (ROTC). A company’s ROCE is a measurement of how efficiently it can generate profits from its assets by comparing net operating profit to capital employed. In high-capital-intensive industries such as utilities and telecommunications, ROCE is especially useful since it also considers debt and other liabilities in addition to the fundamentals. As a result, ROCE provides a better indicator of financial performance for companies with high debt levels.
The 7 key differences between ROC and ROCE
- ROE represents your return on your residual equity capital. ROE only measures the net return on equity of your company. However, ROCE is calculated taking all shareholders into account, including equity and debt. The following only discusses long-term debt with a residual maturity exceeding one year.
- ROE incorporates the impact of leverage since it is post-interest appropriation. Consequently, it represents what equity shareholders retain after servicing debt. ROCE measures the operating performance of the company and how it compares with the equity and debt capital of the company. ROE considers interest as a cost, while ROCE considers interest as a return.
- A ROCE greater than the ROE indicates that the overall capital is being serviced at a higher rate than the equity shareholders. A school of thought holds that if the ROCE is greater than the ROE, debt holders are disadvantaged at the expense of equity holders. It may be true theoretically, but it is not true practically. This is because your obligation to debt holders is limited and known as the sum of interest and principal. Increases in ROCE are a benefit to equity holders only.
- As another benefit, higher ROCE will benefit equity shareholders. ROCE provides a company with the opportunity to borrow and raise capital at attractive terms in comparison to its peers. As a result, it will be able to lower its overall cost of capital and equity. The valuation of the company will be improved. It’s important to remember that the ROCE has a greater impact on your overall cost of funds than the ROE.
- The ROCE is a more accurate measure of capital utilization efficiency. It is essentially a mirror image of the long-term assets of the company since capital here consists of long-term equity and debt. So this also becomes a measure of how efficiently your assets are being used. The return on equity (ROE), on the other hand, is primarily concerned with equity holders and often neglects return on assets, which is very important.
- Is it then that a company with a ROCE that is substantially higher than its ROE is a good case? Perhaps not! An example would be a company with an ROE of 16 per cent and a ROCE of 22 per cent. How should you interpret that difference? Due to the ROE being a measure after the financial cost appropriation, this shows that the company has been borrowing at excessive rates. This means that debt is affecting shareholder returns and has negative implications.
- This comparison of ROE and ROCE is used extensively by Warren Buffett. Buffett prefers companies with ROE and ROCE that are very close to one another. Good companies should have a gap of no more than 100-200 basis points. As a result, both the long-term stakeholders of the company in the form of shareholders and lenders would be catered for. Furthermore, it will ensure that no stakeholder is compromised at the expense of another
Difference by Formula
- ROE = Net Income (Net Profit) ÷ Shareholders Equity Where Net Income is the actual money earned by the company and is taken from 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, it still has to pay the taxes. Therefore, ROCE and ROE values would be different.
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 a 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 a major task to service the debt for such companies. Also, while using ROCE and ROE for analyzing companies, it is important to note that we should choose companies in 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 Consumer Products. We cannot compare HUL with Tata Steel.
ROCE and ROE should be used together to evaluate an organization’s overall performance. By having a higher ROCE value than the ROE value, a company will be able to reduce its cost of capital by efficiently using its debts. If the ROCE of a company is higher, then it indicates that debt holders are getting higher returns than equity holders. Consequently, they provide a more comprehensive picture of the financial performance of the company when viewed together.