Importance of ROE - Return on Equity

RoE (Return on Equity) and RoCE (Return on Capital Employed) calculations have high importance to the investment decisions but those are the less followed tools today. Both of them can provide accurate information about the profit generation capacity of any business if calculated properly. Compare with other ratios and tools, RoE and RoCE known as the most reliable due to its ability to provide accurate data that investor really required.

Buffett has been using both of these metrics together to figure out a company’s profitability and to separate high-debt stocks. Buffett considers RoE a better indicator of the company management’s performance than earnings per share (EPS) which takes into account only the current year earnings.

RoE (Net Income / Shareholder’s Equity), also known as return on net worth, reveals the profit a company makes by deploying shareholders investments. The higher a company’s RoE relative to its industry peers the better it is, as it indicates that the company is utilizing investors money and the surplus funds efficiently to improve its business operations. Companies that generate RoE in excess of the cost of equity are able to add value to their shareholders.

RoCE, on the other hand, indicates how well a company uses its capital (debt and equity) to generate returns for shareholders. Since the company may raise debt to increase RoE, it is, therefore, better to take RoE into account as well before investing in a particular stock.

Now the RoE is what the company can earn on the shareholder's money. Let us assume that the shareholders funds (Capital + Reserves) are $100 crores so with an RoE of 25% this company can earn a profit of $25 crores next year. This year the shre holders funds are now $125 crores (100 + 25) and on this the company can earn another 25% or $31.25 crores. If the company wants to earn $ 50 crores i.e show a growth rate of 40% (40% of $125 crores = $50 crores) it can do so by only increasing the RoE or putting in further debt capital so that the net incremental revenue to the shareholders after deducting for the interest is positive to the extent of $12.5 crore ($50 crore - $37.5 crore). If the RoCE is 20%(Generally it is lower then the RoE) and the interest rate 10% then the company will have to earn a post interest earning of 10% (RoCE (20%) - Interest(10%)). Now to earn a 12.5 crore @ 10% means that the company will have to leverage itself by 125 crores (12.5/10%). (This example has been taken from some place)

Nowadays, retail investors seeking to master the art of harnessing concepts like Return on Equity (RoE) and Return on Capital Employed (RoCE) to get rich as these can easily tell them how much money the are going to make from their investments.