What is a better measure for equities – ROCE or ROE?

Warren Buffett uses it. Charlie Munger uses it. Most Investors from the “Buffett” school of thought use them as first point of reference before going any further.

So what is ROCE and ROE?

ROE – Return on Equity

ROE=Net Income ÷ Shareholders’ Equity

ROE is determined by the above formula to arrive at the net profit the company makes divided by the shareholder of the company.

For the shareholder that’s the first thing he’d like to know i.e how his invested money is being used as against the income generated which in turn will show profits thereof. This equation shows just how well the company’s managers are using the capital to garner more assets and increase profitability from which the Shareholder will eventually benefit. The potential investor would like to know the same.

ROCE – RETURN ON CAPITAL EMPLOYED

ROCE=  EBIT ÷ CAPITAL EMPLOYED

​ (EBIT=earnings before interest and taxes*)

The difference is slight from ROE and the above equation determines the company’s earnings before any tax obligations as EBIT stands for Earnings before interest and taxes. This is divided by the Capital Employed which is (total assets minus current liabilities)

It helps to assess how hard the invested capital in Assets is working for its shareholders.

Key Differences ROE and ROCE

• ROE calculates Net return i.e residual equity capital return. ROCE calculate returns affected to all the shareholders including debt and equity. Lon-term debt program is the major focus of the company with a residual value of the more than 1 year.
• ROE is used to assess how interest / leverage will determine what would be left for the shareholders of the company after its debt is serviced. Interest is assumed to be a cost for the company in-case of ROE. ROCE on the other hand, considers interest as returns. The calculation is used to assess how the company is performing operationally and the company’s measures to service debt and equity.
• Dividends paid out to Shareholders are the main focus when it comes to ROE hence it’s a more eye-catching figure. Return on Capital takes the more conservative approach on to measure how effectively company’s assets are used. This makes ROCE a better indicator of capital utilized because here the capital is sum of equity and debt equal to the assets on the company’s balance sheet.
• For the discerning investor a Higher ROCE is better than a higher ROE because it benefits them directly. Higher ROCE means the company will be able to borrow or raise debt at better terms than its competitors which means cost of capital and cost of the company going down.

Evaluating with ROE and ROCE together

It is advisable to use both ROE and ROCE together while analyzing any stock of a company. A company is supposed to making good use of its debt to reduce its cost of capital if the ROCE is higher than ROE. Higher ROCE also means that it is generating better returns for the company’s debt holders than its equity holders. Warren Buffett mentions that companies should have ROCE and ROE above 20%, also it is better if they are closer to each other as a large difference between them is not good.

Lastly, for the investor both ROE and ROCE are crucial to analyzing the performance of a company. It is advisable to invest in companies which have stable ROCE and ROE number which are close to each other.