Understanding the link between ROE and ROCE in analyzing stocks…

Guide To Fundamental Research | Published on 6th June 2018 | 849

In the world of finance there are a good number of ratios to evaluate companies. There are profitability ratios, efficiency ratios, solvency ratios and liquidity ratios. Within the gamut of profitability ratios, two very important ratios are the Return on Equity (ROE) and the Return on Capital Employed (ROCE). Both these measures look at the company from two different points of view. While the ROE purely looks at the company from what it generates as profits for equity shareholders, the ROCE considers all stakeholders into its calculation. Let us first understand what the concepts of ROE and ROCE are all about?

ROE and ROCE – How do they fit into financial analysis?

Let us first look at ROE. The ROE is the return on equity and is calculated as the quotient of the net profits and the equity of the company. It can be expressed as under:

ROE = Net Profit for the year / Total Equity

Total Equity here refers to the sum total of the share capital, share premium and any other general free reserves created out of profits. This measure drives the dividend policy of the company. Generally, companies with a high ROE can afford to pay fewer dividends to shareholders and plough back a bigger share of their profits into the business, since it has an attractive ROE.

The ROCE is the return that the company generates for its two principal capital providers in the form of equity and debt. ROCE can be expressed as under:

ROCE = Earnings before Interest Tax (EBIT) / (Total Equity + Long Term Debt)

In the above case, the capital employed is the summation of the total equity and the total long term debt which could be in the form of bonds, debentures or term loans. In the numerator the EBIT is used which means the cost of debt and debt as a source of capital is largely ignored by this approach. Let us look at a live example of two companies to understand ROE and ROCE before getting on with the interpretation on valuation of stocks.

Balance Sheet

Company X

Balance Sheet

Company Y

Share Capital

10,00,000

Share Capital

20,00,000

Share Premium

15,00,000

Share Premium

30,00,000

General Reserves

45,00,000

General Reserves

90,00,000

Total Equity

70,00,000

Total Equity

1,40,00,000

Long Term Debt

1,50,00,000

Long Term Debt

3,00,00,000

Total Capital Employed

2,20,00,000

Total Capital Employed

4,40,00,000

Current Liabilities

80,00,000

Current Liabilities

1,60,00,000

Total Liabilities

3,00,00,000

Total Liabilities

6,00,00,000

Fixed Assets

2,20,00,000

Fixed Assets

4,40,00,000

Current Assets

60,00,000

Current Assets

1,20,00,000

Other Assets

20,00,000

Other Assets

40,00,000

Total Assets

3,00,00,000

Total Assets

6,00,00,000

Income Statement

Company X

Income Statement

Company Y

EBIT

20,00, 000

EBIT

25,00,000

Interest Cost

7,00,000

Interest Cost

15,00,000

PBT

13,00,000

PBT

10,00,000

Tax

4,00,000

Tax

2,00,000

Net Profit

9,00,000

Net Profit

8,00,000

Let first calculate the ROE and ROCE for both the companies (Company X and Company Y)

Company X

Ratio Value

Company Y

Ratio Value

ROE
(9 lakh / 70 lakh)

12.86%

ROE
(8 lakh / 140 lakh)

5.71%

ROCE
(20 lakh / 220 lakh)

9.09%

ROCE
(25 lakh / 440 lakh)

5.68%

Comparing the ROE and ROCE numbers of Company X and Company Y

If one were to look at the balance sheet size of Company Y versus Company X, the balance sheet size of Company Y is twice the size of Company X. Company Y is obviously not able to generate profits that are commensurate with the size of the balance sheet. That explains why the ROE and ROCE of Company Y are substantially lower than Company X. Therefore, the immediate focus for Company Y will be to either improve its profitability or to improve its asset turnover ratio so that the ROE and the ROCE can be improved.

There is one more very interesting observation about comparing the ROE and ROCE ratios of Companies X and Y. In case of company Y, the ROE and the ROCE are at the same level. That means the company is rewarding debt holders and equity holders similarly, which is not appropriate considering that equity shareholders take on more risk. In case of Company X, the ROE and the ROCE are more balanced with the ROE enjoying a 377 basis points premium over the ROCE, justifying the higher risk that equity shareholders take on.

Three specific insights that follow from the ROE / ROCE comparison

The legendary Warren Buffett has a simple rule for a good stock. A good stock, according to Buffett, is one that has a healthy ROE level of above 15% and an ROCE level that is hovering around the ROE level and not too far. There are 3 specific insights that flow from this ROE / ROCE comparison. Firstly, the ROCE is agnostic to the capital structure. Since the ROCE considers the EBIT as the numerator, it glosses over the cost of debt funding. When you compare the ROCE with the ROE, the cost of debt and the inherent financial risk become obvious. Secondly, ROE is a good lesson on how to adopt a dividend payout policy. A company with high ROE should have a low dividend payout and a company with low ROE should typically have a high dividend payout. Lastly, the ROCE is the starting point and serves as a guide for tweaking the extent of debt and the cost of debt so that the ultimate ROE is not compromised.