Return on Equity (ROE) is by now a well understood concept. Calculated as the ratio of the Net Profits to the Equity of the company, the ROE shows how much the company earns for its residual stakeholders, the equity contributors. But most analysts use another interesting concept of returns which is called the Return on Capital Employed (ROCE). How is the ROCE different from the ROE? While the ROE only considers the net return on equity, the ROCE considers returns to all stake holders. For example, in a business both equity shareholders and long-term lenders provide capital. We are not talking about the working capital and short term loan providers. But there is a significant portion of long term funding that comes in the form of term loans from banks, long term bonds, international FCCBs etc. ROCE factors the return to all these stakeholders.
Comparing the ROE versus the ROCE..
There are 7 points you need to understand when you compare the ROE versus the ROCE of a company..
The ROE captures the returns on your residual equity capital. It only considers the net return on the equity of the company. The ROCE considers the return to all stakeholders in the company including equity and debt. The focus here is only on long-term debt with a residual maturity of more than 1 year.
The ROE factors the impact of leverage as the PAT is a post-interest appropriation. It therefore captures what is left for equity shareholders after the debt has been serviced. The ROCE focuses on the operating performance and how it measures up to service the equity and the debt capital of the company. While ROE considers interest as a cost, the ROCE considers interest as returns.
When the ROCE is greater than the ROE, it means that the overall capital is being serviced at a higher return than the equity shareholders. There is a school of thought that if the ROCE is greater than the ROE it means that debt holders are advantaged at the cost of the equity shareholders. While that argument is theoretically right, it is not practically true. That is because your commitment to debt holders is anyways limited and known as the summation of interest and principal. A higher ROCE only leaves a greater surplus for the equity shareholders.
Equity shareholders will also benefit from a higher ROCE in another way. When a company has a high ROCE, it is able to raise debt and equity at attractive terms compared to the peer group. That means its cost of equity and its cost of capital overall will come down. This will help to improve the valuations of the company. Remember, the ROCE makes a much bigger difference to your overall cost of funds compared to your ROE.
ROCE is a better indicator of the efficiency of utilization of capital. Since capital here becomes the sum of equity and long term debt, it is virtually a mirror image of the long term assets of the company. In other words, this also becomes a measure of the efficiency of the usage of your assets. ROE, on the other hand, is purely focused on equity shareholders and tends to gloss over the very important aspect of return on assets.
So does that mean that a company with ROCE substantially superior to ROE is a good case. Well, not necessarily! Let us take the case of a company that has an ROE of 16% but an ROCE of 22%. How should you interpret this gap. Since the ROE is a measure after the financial cost appropriation, this indicates that the company has been borrowing at an inordinately high cost. That means that the high cost of debt is impacting returns to shareholders and is not a very good sign.
What does the legendary Warren Buffett thing about this comparison? Interestingly, Warren Buffet uses this comparison of ROE and ROCE very extensively. Buffett's view is that he would prefer companies that have ROE and ROCE that are very close to each other. Ideally, for a good company, the gap should not be more than 100-200 basis points. This will imply that both the long term stake holders of the company in the form of shareholders and lenders are properly taken care of. It will also mean that any set of stakeholder is not being compromised at the cost of other.
ROE and ROCE are among the most critical measures of value creation. In fact, they form the basis for equity and credit analysts. As Warren Buffett explains, "The closer the ROE and the ROCE are to each other, you can be rest assured that the company is aligning the interests of its stakeholders and harnessing it in the larger interests of the company." That is, after all, the crux of valuation!
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