For share market investors, it is useful to know what is RoCE. Moreover, seeing “RoCE vs ROE” in conjunction can unearth future potential of a company.
By simply looking at ROE and RoCE formula, immediate difference between the two can be identified.
What is ROE and RoCE?
Both these metrics are a measure of company’s profitability. Means, they highlight how well the company uses its funds (capital). But ROCE gives a better measure of company’s profitability than ROE. How?
- ROE: Return on Equity (ROE) is a measure of how much net profit company is making for every invested Rupee of shareholders money. ROE highlights the profitability from the point of view of ‘investors’ only. High ROE does not necessarily mean that the overall business is also profitable.
- RoCE: Return on Capital Employed (RoCE) is a measure of how much operating profit (EBIT) company is making for every Rupee of capital used for its operations. RoCE highlights the profitability of the overall business. High RoCE invariably means that the business is profitable. But there are limitations. We will see how.
High ROE is an essential metric for shareholders. But high RoCE benefits a wider audience. How? When EBIT is high, Government will collect more tax. Lenders are assured that their loans will be paid back. Shareholders are assured of higher returns (dividend, appreciation or both).
So for a prospective stock investor – looking at a combination of ROE and RoCE is a good idea.
Importance of Employed Capital
Money (capital) is required to run the operations of a company. When this “capital is employed”, it is used to buy fixed assets (land, building, machinery etc). The capital is also used to pay for the expenses (vendor payments, salaries, utility bills, interest, tax etc). This funding in turn generates sales and profits.
Out of the process shown above, often equity is a small portion of total capital. Hence, ROE is not reflective of the total profitability of a business. Nevertheless, from investors (shareholders) perspective, ROE serves the purpose.
But to understand the overall profitability of the business, use of only ROE can be misleading. A better metric for this will be RoCE.
Most business utilise debt (long term) to buy assets. More assets eventually leads to more sales and profits. But we also know that use of debt must be done prudently.
How to know if the company is using its debt wisely? This can be done by using the RoCE metric. If RoCE ratio is higher than the average interest rate paid by the company on its debts, it is a sign of better debt utilisation.
RoCE vs ROE Comparison
Companies take debt to benefit from leverage. These are such companies, which generates more returns for its shareholders, if they take debt.
If such a company remains debt free, it generates Rs.X net profit (say). But if this company takes debt, it will generate Rs.(X+1) net profit. This is a case of higher profits (PAT) when debt is included in the “employed capital”. High PAT means, higher ROE (better shareholder value).
But this does not mean that high ROE companies can go on pilling up debts for the sake of increasing ROE. There must be a balance. Why? Because too much debt will make the company vulnerable and risky.
So what is the control point? A balance between ROE, RoCE, and Debt Equity ratio (D/E). A combination of high ROE, high RoCE and low D/E (less than 1) is what companies must look at.
When we are comparing ROE, RoCE and D/E, we are basically interpreting the effect of debt on companies profitability. To get a better understanding of the effect of debt, let’s do these things:
- Learn to calculate ROE, RoCE and D/E.
- Interpret the effect of debt on company’s ROE, RoCE and D/E.
Calculating ROE, ROCE and D/E
In this example, we will see how to calculate ROE, RoCE and D/E from the numbers in the financial reports of a company. We are taking example of Grasim & Crompton Greaves (CG).
|Equity Share Capital||a1||131.52||125.4|
|Net Worth (Total Equity)||A = a1+a2||41,929.34||1,098.48|
|EBIT||C = c1-c2||1,505.25||621.16|
|Net Profit (PAT)||C-D-E||509.81||402.52|
Return on Capital Employed (RoCE) = EBIT / Employed Capital
- RoCE = 1,505 / 44,832 = 3.4% (Grasim).
- RoCE = 621 / 1,447 = 42.9% (CG).
Return on Equity (ROE) = PAT / Equity
- ROE = 509 / 41,929 = 1.2% (Grasim).
- ROE = 402 / 1,098 = 36.6% (CG).
Debt to Equity Ratio (D/E) = Total Debt / Equity
- D/E = 2,903 / 41,929 = 0.07 (Grasim).
- D/E = 349 / 1,098 = 0.32 (CG).
As you can see, calculation of ROE and RoCE is straight forward. Most of the numbers required for the calculation are available upfront in the financial reports.
[General Note: CG is able to generate almost as much PAT (402 Cr) as Grasim (509 Cr). But CG is doing it with 96% less capital (1,447 Cr) than used by Grasim (44,832 Cr). Hence CG’s ROE and RoCE numbers are much higher compared to Grasim. Though D/E numbers of CG is higher than Grasim, but still CG looks more profitable.]
1. What it means when ROE is High?
For companies whose ROE is high [like Crompton Greaves (CG), 47%], they should better retain their earnings (profits).
Company generates net profit (PAT). A part of PAT is paid as dividends to shareholders. The balance what remains is called “retained earnings”. Retained earnings are invested back into the business.
Every year the retained earning is transferred to the companies balance sheet. The cumulative retained earnings in balance sheet is called “reserves”.
For companies whose ROE is as high as CG’s, they can service shareholders better by reinvesting their profits back to business instead of paying high dividends. Why? Because reinvestment will result in faster future price appreciation of its shares.
2. What it means when RoCE is High?
High RoCE means the company is utilising its capital more economically. Generally speaking, company’s RoCE must be higher than a minimum level. What is the minimum level? It is called Cost of Capital.
If this is not the case, it means debt is detrimental to the company. Such companies are doing disservice to their shareholders by including high debts in its capital structure.
To understand this, let’s consider two hypothetical cases.
A company XYZ has zero debt. As debt is zero its interest expenses will also be zero. What will be its capital employed? Employed Capital = Equity + Debt = Equity + Zero = Equity.
In this case what will be XYZ’s ROE and ROCE. As EBIT is always greater than PAT, in this case, RoCE will be more than ROE. It means, for a debt free company, ROCE will be always be more than ROE.
Now suppose XYZ takes some debt from bank. Because of debt how ROE and ROCE will change? To get a better clarity, lets compare ROE of Case 1 with Case 2. It is interesting to note what is happening here. As XYZ has taken debt, it is leading to following 2 effects:
- Positive: EBIT is increasing (delta C).
- Negative: Expense has increased in form of interest (D).
It must be noted that, as soon as XYZ takes debt, its RoCE will fall. It means, RoCE of case 1 (debt free) will always be higher than RoCE of case 2 (with debt).
From investors point of view, falling RoCE (due to new debt) should not be a problem, till it is increasing the ROE.
To understand this, let’s see two more conditions one by one.
- #1 RoCE is equal or less than Cost of Capital: In this case increase in EBIT (delta C) will be equal or less than interest expense due to debt (D). Net effect of availing debt on companies profitability is zero (or negative). Such debt financing is not beneficial for shareholders. So, when RoCE is too low (below cost of capital), debt is actually decreasing the company’s ROE.
- #2 RoCE is more than Cost of Capital: In this case increase in EBIT (delta C) will be more than interest expense due to debt (D). Such debt financing is beneficial for shareholders. So, when RoCE is high (above cost of capital), debt is actually increasing the company’s ROE.
RoCE and ‘Cost of Capital’
Cost of Capital = Cost of Equity + Cost of Debt.
This is the formula of cost of capital. But to get a better meaning out of it, let’s try to calculate cost of capital of a decent company in India (assuming stock beta as 1).
- Cost of Equity (Ce): Cost of Equity = Risk Free Rate + Risk Premium. At present risk free rate is 6.5%. Assuming expected risk premium as 1%. Cost of equity for the company will be 7.5% (6.5+1.0).
- Cost of Debt (Cd): Suppose average interest rate paid by the company on all its long term debt is say 6.9% p.a. In this case cost of debt for the company can be 6.9%.
Total Cost of Capital = Ce+Cd = 7.5% + 6.9% = 14.4% p.a.
How a company see’s these numbers? For the company, 14.4% is the minimum profitability level at which it should operate. Why? Because it needs to feed 7.5% p.a. return to shareholders, and feed 6.9% interest to its borrowers.
A number less than 14.4% means, shareholders return are going to suffer. Why only shareholders will suffer? Because banks will take their interest any ways. Only equity borrowers shares the risk of the company.
If RoCE is greater than cost of capital, it a sign for shareholders to stay invested in the company. But if RoCE is lower, it is a sign for shareholders to exit. For new investors, it is sign to stay away.
The higher is the ROE and RoCE the better. But how we, as an investor, can make more meaning out of these numbers.
We can take few thumb rules to decode the puzzle:
- Same Sector: It will not be effective to compare stocks of different sectors. Better is to compare stocks of same sector. Why? Because nature of business of each sector is unique. Some business lines are inherently more profitable than others. Hence ROE and RoCE of two separate business lines cannot be compared.
- ROE: In India, a decent debt based mutual fund can yield a return of 9% per annum. So if one decides to invest in equity, minimum return expectation will be higher than 9% (say 12%). So, a profitable company will aim to keep their ROE levels well above it (like 15%+).
- RoCE: In India, corporates can avail debt at an interest rate of 8% p.a. So, a profitable company will aim to keep their RoCE levels well above it (like 10%+).
- Ideal Company: For me, in India, an ideal company will be one which is yielding ROE and RoCE above 25% p.a (15%+10%). It is also imperative to note that, ROE, ROCE and D/E must remain in balance. Hence ROE, RoCE above 25% and D/E close to one (1) is a good indicator of financially healthy company.
As an investor, we must be in look-out for such companies whose increase in debt in complemented with similar increase in EBIT. Why? Let’s know more:
Suppose a company has RoCE of 18%. It has decided to take more debt (20% more) to fund its capital procurement. To maintain the same level of RoCE, EBIT of the company must also increase by 20%.
Another situation: The higher is the ROE the better. But it is also essential to note that the difference between ROE and ROCE should not be too high.
In case of Zero Debt company, ROCE will be higher than ROE. But when debt is availed: ROCE will decrease due to “B” (debt) in denominator. ROE will increase due to increase in PAT.
But if ROCE falls too low, compared to ROE, it means increase in EBIT is not happening enough. Too low RoCE is also not good for the shareholders. Why? Because ultimately ROE will be effected.
What such a company must do? It must try to lower its debt burden. How much debt must be lowered? Lower D/E ratio till ROE and ROCE comes reasonably close. Remember, ROE and RoCE close to 25% indicates a profitable company.