Investors can use various methods to compare different companies within the same sector. One tool is to measure the return in equity and also return of capital employed. In this article we discuss what the difference is between the two.
Return on Equity
The return on equity (ROE) ratio is a tool that investors can use to compare companies from the same industry to identify which is the best out of the group. It essentially measures how effective management uses shareholders equity and turns it into income. The focus on this ratio is how well the shareholder equity is used.
The formula is net income/shareholders’ equity
The net income is the profit before dividends are paid to investors. The shareholders equity is calculated by taking assets minus liabilities.
High ROE may indicate the company is efficient at generating profits from shareholders equity.
This ratio however does not take into account debt which can give investors a misleading picture as the company may have a high ROE but have high debt. High debt can be problematic if the company is struggling to service the debt but this ratio will not identify such issues. Company buybacks can also distort this ratio as this corporate action can decrease shareholder equity and increase the ROE but nothing has changed within the business.
Return on capital employed
The ratio of return on capital employed (ROCE) analyses more effectively how the company is using their capital to create profits. This ratio can demonstrate how efficient the company is run. A high ROCE indicates that the company is well run which can be translate into higher profits for the company. This ratio does not just focus on the profitability on shareholders equity but the profitability of the company. A high ROCE may also mean the cash flow is solid. Investors should analyse ROCE for a few years and evaluate the level of consistency of the ROCE levels.
The formula for this is ROCE = EBIT/Capital Employed
EBIT is earnings before interest and taxes
Capital employed is total assets minus current liabilities
Unlike ROE, the ROCE ratio takes into account company debt and equity which can give a more transparent picture for companies which have large liabilities on their balance sheet. Total assets minus current liabilities will show you shareholders equity plus long-term debts.
Lauren Hua is a private client adviser at Fairmont Equities.
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