# ROE and ROCE - In Stock Market Terms

April 06, 2022

**ROE and ROCE - In Stock
Market Terms**

** **

Investors choose various
financial metrics when it comes to analysing a particular stock and whether it
offers them a bang for their buck or not. Some choose to look at operating cash
flow, while others look at dividend yields. There are also some who prefer
Price-to-Earnings (P/E) multiples while others look at Price-to-Book Value
(P/B) while mostly analysing banking stocks.

Some investors also prefer to look at two other financial metrics for analysing stocks. One is ROE - Return on Equity and the other being ROCE- Return on Capital Employed. Both are generally used together to gauge the operational efficiency of a company and the potential for future growth in value.

Let's first take a look at ROE.
Return on Equity is what a company generates for its shareholders after paying
taxes but before paying dividends. It is therefore used to determine how much
surplus a company generates that either needs to be allocated to shareholders
as dividend or reinvested into the business.

·
**How can you calculate
ROE? **

** **

To calculate ROE, divide the
company's net profit by the shareholders' equity and multiply it by 100.

So, if a company has made a net
profit of Rs. 70 crore and has a shareholder equity of Rs. 140 crores, the return
on equity will be 50%. The ROE represents the firm’s ability to turn equity
investments into profits. The above figure means that the company is able to
generate a profit of Rs 0.50 for every Re. 1 that it invests.

**A higher ROE suggests that a
company is more efficient when it comes to deploying shareholder capital.** A
rising ROE means that a company is managing to generate greater profits without
needing as much capital in proportion. On the other hand, a lower ROE would
mean that a company may have some management issues and could be reinvesting
earnings into unproductive assets.

However, a higher ROE may not
necessarily mean that a company has been successful in generating profits
internally. A company may also rely on debt to generate a higher net profit,
thereby pushing the ROE higher. A company with a debt/equity ratio of 4x
generates an ROE of 13% as compared to a company with a debt/equity ratio of 9x
and an ROE of 23%.

·
**How can you calculate
ROCE?**

ROCE measures the return on
capital employed to reflect upon how efficiently the company is utilizing its
capital to generate profits.

ROCE considers EBIT (Earnings
before Interest, Tax) as the numerator while capital employed acts as the
denominator.

How do you calculate the Capital Employed?
That can be done by subtracting the total assets of the company with its
current liabilities and adding long-term debts of the company.

Therefore, ROCE= EBIT / Capital
Employed

**The higher the value of the
ROCE, the better are the chances of obtaining a profit. **

** **

Let us consider a company that has an EBIT of Rs. 10 crores.
It has employed capital worth Rs. 34 crores. On dividing the two, we get a ROCE
of 29.4%.

** **

·
**So, why is ROCE
important? **

ROCE considers other stakeholders
like lenders and debt holders, unlike ROE. It is a better measure when you are
evaluating companies that have a longer gestation period like power,
infrastructure, and telecom.

To conclude, can you choose one
over the other? Ideally, the best way to analyse a company is by taking a look
at both the numbers. When a company's ROCE is greater than ROE, it means that
the company is utilising its debt well to reduce its overall cost of capital.
However, it may also mean that debt holders are being rewarded more handsomely,
as compared to equity holders.

In the words of the legendary
Warren Buffett, both ROE and ROCE should be greater than 20%. The closer they
are to each other, the better. A large divergence between the two, on either
side, and you may have second thoughts about the company and whether you should
invest in it or not.

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