Both ROE and ROCE are much important whilst performing the fundamental analysis of companies.
RETURN ON EQUITY
ROE is the measure of the net income of a company divided by its shareholders’ equity (expressed in percentage). It shows the capability of a company to make profits from the equity investments. In other words, it measures the profit made from its shareholders’ equity.
RETURN ON EQUITY FORMULA
ROE = Net Income Shareholders’ equity
The Net Income is the net money earned by the company and is taken from last 12 months. The Shareholders Equity includes Equity Capital, Reserves & Surplus and Retained Earnings.
IMPORTANCE OF RETURN ON EQUITY
ROE identifies the company’s bottom line to measure the total profit for its investors and holders. It also helps in governing the excess profits which can be used for reinvesting in the business.
Using ROE, the company can assess its efficiency in utilizing the equity. Likewise, the investors can make sure if they are earning a good return for their money.
A company with high ROE is more successful in creating much profit internally. Still, it doesn’t completely display the risk related to the return. Furthermore, always keep in mind that this is a ratio and the companies can artificially increase it by decreasing the equity of shareholders.
RETURN ON CAPITAL EMPLOYED(ROCE)
ROCE is the ratio that measures the efficiency of a company in utilizing its capital to create profit. Investors mostly use this ratio for identifying best companies for investing. Thence, it is the most commonly used profitability ratio.
ROCE = EBIT Total Assets – Current Liabilities
*EBIT= Earnings Before Interest and Tax
IMPORTANCE OF ROCE
ROCE identifies the operating income created for each dollars of invested amount. Unlike some profitability ratios that decide the profitability related to the shareholders’ equity, ROCE analyzes equity and debt. Consequently, helps the firms with serious debt to analyze their financial performance in order to balance their condition.
Moreover, a company with higher ROCE shows powerful profitability as it indicates that the company can generate more profit for each dollar. Usually, investors consider companies with stable ROCE over years.
THINGS TO CONSIDER
Logically, both ROCE and ROE would be same (if the company did not have any debt).
Technically speaking, even if the company doesn’t have to pay any interest on the debts but it still has to pay the taxes. In that case ROCE and ROE values could be different. Whilst considering the ROCE and ROE for performing the Fundamental Analysis of companies, it is much important to consider that one should choose the companies of the same sector. For example if you are comparing companies ROE/ROCE , choose companies like Maruti , Tata Motors etc. as both are from same industry.