ROE vs ROCE -What’s the difference?

Picture this: You’re at a family gathering, and your uncle proudly announces he’s opened two shops – one with his own money and another with both his savings and a bank loan.

Which shop would you consider more successful?

The one making ₹1 lakh profit from ₹10 lakhs of his own money, or the one making ₹1.5 lakhs from a total investment of ₹20 lakhs (₹10 lakhs own + ₹10 lakhs loan)?

This is exactly where ROE and ROCE come into play in stock market investing.

I’ve noticed that many investors focus solely on ROE, missing the bigger picture of how efficiently a company uses ALL its available capital.

Think of ROE as how well a company is using your money (equity), while ROCE tells you how efficiently it’s using all available money (equity + debt).

Or

RoE vs RoCE: ROE stands for return on equity and is calculated by dividing the net income for the period by the net worth of the company.

ROE is an important metric in business since it shows how much money the company makes for each dollar that’s invested in it.

ROCE stands for return on capital employed and is calculated by dividing the profit for the period by the total capital employed in the company.

ROE vs ROCE – Understanding the difference

Let’s break this down with a real-world example:

Take two companies in the FMCG space – Company A and Company B. Both show an ROE of 20%, making them appear equally profitable at first glance. However, when we dig deeper:

Company A:

• Net Profit: ₹100 crores
• Shareholder’s Equity: ₹500 crores
• ROE = 20%
• No debt

Company B:

• Net Profit: ₹100 crores
• Shareholder’s Equity: ₹500 crores
• Debt: ₹500 crores
• ROE = 20%
• ROCE = 10%

See what happened here? Despite showing the same ROE, Company B is actually less efficient at using its total capital. This is something I learned the hard way during my early investing days.

Return on equity (ROE)

Return on equity measures the efficiency of the company’s operations by dividing net income by the amount of equity. Return on equity provides an indication of the effectiveness with which management has used shareholders’ contributions to generate profits.

Return on equity formula

ROE is a financial metric that measures a company’s efficiency in generating profit relative to its shareholders’ equity. It is calculated as the ratio of a company’s net profit to its equity.

• Net Profit: It is the profit remaining after deducting taxes, interest expenses, and dividend payments to preferred shareholders.
• Equity: It is the difference between a company’s total assets and total liabilities (Equity = Assets – Liabilities).

ROE helps in making sense of two key financial statements: the income statement and the balance sheet. It incorporates the net profit from the income statement and the shareholders’ equity from the balance sheet to provide a comprehensive measure of profitability.

Example: Understanding Return on Equity (ROE)

Let’s take the example of two ice cream companies, Company A and Company B, to understand ROE better.

In the financial year 2019-20, both companies reported a profit of ₹20 lakhs. At first glance, it seems like both companies performed equally well.

But how do we know which company uses its shareholders’ money more efficiently?

To answer this, we need to consider the investment each company received:

• Company A: ₹1 crore
• Company B: ₹2 crores

Now, let’s calculate the ROE:

• ROE for Company A = Net Profit ÷ Equity = ₹20 lakhs ÷ ₹1 crore = 0.2 (or 20%)
• ROE for Company B = Net Profit ÷ Equity = ₹20 lakhs ÷ ₹2 crores = 0.1 (or 10%)

This shows a new dimension of profitability. Although both companies earned the same profit, Company A’s management is more efficient in converting the investment into profit.

Therefore, Company A provides a higher return on the money invested by its shareholders, making it a more attractive investment.

Importance of Tracking ROE Over Time

When we compare a company’s ROE over several years, it reveals how efficiently the management has been using equity:

• An increasing ROE shows that the company’s management is allocating shareholder capital wisely, generating better returns over time.
• A declining ROE, however, suggests potential issues, such as poor investment decisions or inefficiencies in raising and using funds.

By regularly monitoring ROE, investors can better evaluate how well a company is being managed and whether their investment is likely to grow profitably.

Return on capital employed (ROCE)

ROCE is a financial metric that measures how efficiently a company uses its capital to generate profits.

It is calculated by dividing the company’s operating income (EBIT) by its invested capital. This ratio gives insight into the effectiveness of a company’s capital allocation.

How to Calculate ROCE

The formula for ROCE is:

Understanding the Components:

• Operating Income (EBIT):
  This refers to the company’s earnings before interest and taxes. It represents the profit left after deducting operating expenses like labor costs, depreciation, and production costs. Essentially, EBIT shows the core profitability of the company’s operations.
• Invested Capital:
  This is the total capital the company uses to generate profits. It can be calculated as:

ROCE is particularly useful when comparing companies within the same industry, as it highlights how well they allocate their capital to generate returns.

Higher ROCE values indicate better efficiency and profitability.

Example of understanding ROCE

Let’s revisit the example of two ice cream companies, Company A and Company B, to understand ROCE.

Both companies earned a profit of ₹20 lakhs in a financial year. They also had the following investments and debts:

• Company A: Investment of ₹1 crore and loans totaling ₹3 crores.
• Company B: Investment of ₹2 crores and loans totaling ₹1 crore.

Calculating ROCE:

• ROCE for Company A = Operating Profit ÷ (Equity + Debt) = ₹20 lakhs ÷ ₹4 crores = 0.05 (or 5%).
• ROCE for Company B = Operating Profit ÷ (Equity + Debt) = ₹20 lakhs ÷ ₹3 crores = 0.067 (or 6.7%).

This comparison highlights how efficiently the two companies used their total capital to generate profits. Company B emerges as the more efficient business, suggesting it could be a better investment option.

Why ROCE Matters

ROCE evaluates the total capital employed in the business, making it essential to compare it with the cost of capital:

If ROCE is lower than the cost of capital: This is a warning sign. It suggests that the business is not generating sufficient returns to justify the capital employed.

In such cases, existing shareholders may consider selling their stake, and new investors may avoid investing.

If ROCE is higher than the cost of capital: This indicates the business is generating enough returns to cover its capital costs, making it a profitable investment.

ROE vs ROCE: Main differences

Use ROE or ROCE?

The choice between ROE and ROCE depends on what aspect of a company’s performance you want to evaluate:

• Use ROE when you want to focus on how efficiently a company is generating returns for its shareholders. It’s ideal for investors assessing equity returns.
• Use ROCE when you want a broader view of the company’s efficiency in utilizing all its capital, including both equity and debt. It’s especially useful for analyzing businesses with significant debt or for comparing companies across industries.

Main Points:

If you’re analyzing overall operational efficiency, especially for debt-heavy companies, ROCE is the better metric.

If you’re an equity investor, prioritize ROE. <- Explained below

Can ROE and ROCE be combined?

Yes, ROE and ROCE can be combined to provide a more comprehensive understanding of a company’s financial performance. Here’s how:

Combining ROE and ROCE:

1. Evaluate Shareholder Efficiency with ROE:
   • ROE highlights how well a company uses shareholders’ equity to generate profits.
   • It focuses solely on the equity portion, making it valuable for equity investors.
2. Assess Overall Capital Efficiency with ROCE:
   • ROCE measures how efficiently a company employs both equity and debt to generate returns.
   • It’s particularly useful for companies with significant debt or diverse capital structures.
3. Identify the Cost and Impact of Debt:
   • Comparing ROCE and ROE together can help understand the impact of leverage (debt).
   • If ROCE is greater than the cost of debt and ROE is higher than ROCE, it suggests that the company is using debt effectively to boost shareholder returns.
   • If ROCE is lower than the cost of debt or ROE lags behind ROCE, it indicates inefficiency or poorly managed leverage.
4. Better Industry Comparisons:
   • In industries with varying debt levels, using both metrics helps investors see how equity and debt contribute to profitability.

Practical Use Case:

Suppose a company has high ROE but low ROCE. This could mean that while shareholders are earning good returns, the company’s overall operations might be inefficient or overly reliant on debt. On the other hand, if both ROCE and ROE are high, it signals both operational and shareholder efficiency.

Can ROE/ROCE be industry-specific?

Yes, ROE and ROCE can vary significantly by industry, and their relevance and interpretation often depend on the nature of the business. Here’s how industry specificity affects these metrics:

ROE/ROCE in Different Industries

1. Capital-Intensive Industries (e.g., Manufacturing, Utilities):
   • ROCE is more important because these industries require substantial investments in assets and often operate with significant debt.
   • A high ROCE indicates efficient use of the capital-heavy structure to generate returns.
2. Service-Oriented or Tech Industries (e.g., Software, Consulting):
   • ROE is more significant as these companies typically have lower capital requirements and focus more on equity returns.
   • Investors are interested in how effectively the company generates profit from equity investments.
3. Financial Services (e.g., Banks, Insurance):
   • ROE is critical, as these businesses primarily use shareholders’ equity to generate income. A high ROE is often a benchmark of success in this sector.
   • ROCE may be less meaningful since these companies don’t operate with traditional fixed assets or debt structures.
4. Real Estate and Infrastructure:
   • Both ROE and ROCE are relevant.
   • ROE reflects equity returns, while ROCE highlights the ability to generate returns from the heavy use of debt financing common in these sectors.
5. Retail and Consumer Goods:
   • ROCE is key because these companies rely on managing working capital and inventory efficiently. A high ROCE indicates operational efficiency.
   • ROE can also be considered, especially for investor-focused analysis.

Why ROE/ROCE Differ by Industry

• Capital Structure Differences: Industries like utilities often have high debt levels, making ROCE crucial.
• Asset-Intensity: Capital-heavy businesses benefit more from ROCE analysis, while asset-light sectors (e.g., tech) prioritize ROE.
• Business Models: Service industries with minimal fixed assets lean toward ROE, while industries with significant fixed costs require ROCE evaluation.

Conclusion

The relevance of ROE and ROCE depends on the industry’s characteristics:

• Use ROCE for industries with high capital requirements.
• Focus on ROE for industries driven by equity returns.

When analyzing companies, always compare ROE/ROCE to industry benchmarks to ensure meaningful insights.

Why Equity Investor should focus on ROE ( and when not to)

1. Focus on Shareholder Returns:
ROE directly measures how effectively a company uses shareholders’ equity to generate profits. For equity investors, this is critical because it shows how their investment is being utilized to create value.

• Example:
  Imagine two companies, Company A and Company B, each with a profit of ₹50 lakhs.
  • Company A has ₹1 crore in shareholders’ equity, resulting in an ROE of 50% (₹50 lakhs ÷ ₹1 crore).
  • Company B has ₹2 crores in shareholders’ equity, resulting in an ROE of 25% (₹50 lakhs ÷ ₹2 crores).
    An equity investor would likely prefer Company A because it generates higher returns on the equity invested, showing better efficiency and profitability.

2. Indicator of Management Efficiency:
ROE reflects how well a company’s management uses shareholders’ funds to grow profits. Consistently high ROE indicates efficient allocation of resources and strategic decision-making.

• Example:
  Consider a technology company with minimal debt and high ROE (e.g., 30%). This suggests management is successfully leveraging innovation and low capital requirements to maximize equity returns, making it attractive to equity investors.

3. Industry Comparisons for Equity Investors:
ROE helps equity investors compare companies within the same industry, offering a clearer picture of which company delivers better returns on their equity.

• Example:
  In the banking sector, where leverage is common, ROE is a standard metric for assessing profitability. A bank with ROE of 15% would be seen as performing better than one with 10%, assuming other factors like risk and market conditions are similar.

4. Avoid Over-Leveraged Companies:
High ROCE can sometimes be influenced by heavy debt, which may not benefit equity investors. ROE, by focusing solely on equity, avoids this distortion.

• Example:
  A capital-intensive manufacturing company might show a high ROCE (say, 20%) due to substantial debt, but its ROE might be low (e.g., 8%), signaling lower returns for equity holders. For equity investors, this low ROE is a red flag.

When to Consider ROCE Alongside ROE

While ROE is vital for equity investors, ROCE can complement ROE analysis in cases where debt plays a significant role in financing the company. If ROE is high, but ROCE is significantly lower, it could indicate that high debt is boosting equity returns artificially.

Also read: Key financial ratios for investors

What does Warren Buffett say about ROE and ROCE?

When evaluating companies based on ROE and ROCE, Warren Buffett prefers companies whose ROE and ROCE are close. In his opinion, the spread of a good company should not exceed 100 to 200 basis points. A situation where ROE and ROCE are close implies that shareholders and lenders are concerned about themselves. And no compromising at the expense of the other.

Frequently Asked Questions