Understand ROE vs ROCE: So you’ve begun your investment journey and you’re learning about the markets. Or you’ve just begun and even though you don’t invest, you like to keep yourself updated with daily market movements.
Either way, you’re likely to come across money metrics about stocks every time you screen them. Now, this doesn’t change from one stock to another. They’re always the same financial metrics and ratios that matter when you’re picking stocks.
Some important terms that are used when looking at stock are CMP or current market price, P/E ratio, EPS (earnings per share), ROE, and ROCE. This blog will take you through ROE vs ROCE and explain what makes them different from each other.
Knowing the Difference Between ROE & ROCE
Let’s take a look at this blog on ROE vs ROCE and see what the differences are.
Return On Equity – ROE
When you make an investment into a company, in the form of shares, you’ll want to know how your investment is performing. ROE is one of the best metrics used by shareholders to understand exactly this movement.
To explain it simply, ROE is the return on your money invested into the company, which is calculated per share. ROE is the percentage of the net income of a company, divided by the equity held by shareholders.
The formula for ROE shown below helps investors understand the overall profitability of the company so far, and also the efficiency of the company to turn its shareholder capital into profits.
Net income is the money generated by the company in a year, after deducting the expenses and costs in the same year. This includes – Preferential shareholder payout as well and does not include dividends paid to equity shareholders.
Remember – A higher ROE means that a company is working efficiently using shareholders’ capital and thereby growing business and profits.
Although this is conditional to the capital intensiveness of the industry, ROE is an important factor to understand. Some industries such as telecommunications and oil and gas are capital intensive so they will have lower ROEs compared to IT and FMCG companies, which are less capital intensive and have a higher ROE.
ROE is not limited to measuring only the profitability of the company, but also how well the company is reallocating capital to its business for future growth. This future growth is directly dependent on how much the profits are directly reinvested into the company the following year.
Return On Capital Employed – ROCE
A quick glance at ROE tells you that it looks at capital use primarily from the point of view of the equity shareholders. But a company does not generate capital solely from equity alone.
It issues bonds, debentures, preferred stock, and lenders, all of whom are also stakeholders and all of whom are also looking for a return on their investment.
Now, stakeholders may receive a fixed interest rate on their investment, but all their holdings add up to the additional capital that is not considered in the ROE formula.
Capital Employed = Total Assets – Current Liabilities
ROCE is the measure of all capital, not only equity, and how it is used to generate additional profit.
In the formula above, the numerator shows EBIT, which is the operating profit of the company before deducting interest payments and taxes. The denominator shows long-term equity and debt capital.
ROCE is useful when measuring performance in capital-intensive companies such as telecom, oil, gas, utilities, etc because ROCE considers debt capital as well, unlike ROE.
This is important when you’re looking at debt-financed companies that operate on borrowed funds more than other sources of capital.
Generally, ROCE higher than ROE is a good indicator, and investors prefer companies that have a positive, consistent year-on-year growth of ROCE. This is better than the volatile ROCE movement, especially when investing in stocks in the long run.
ROE vs ROCE Comparison Table
When looking at ROE, it is very useful from a shareholder perspective. But when you’re looking at the business as a whole, then ROCE tells you a better picture. Check out the courses section for similar topics on capital markets. That’s all for the article on ROE vs ROCE, hope you liked it. Happy Investing!
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