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Company Fundamentals – ROA, ROE, ROCE, and ROIC: Explained!

March 28, 2023

ROA, ROE, ROCE, and ROIC: Explained! Finding quality stock from many listed companies is like finding a small needle in a big pile of hay. Hence, retail investors have always been asked to check the financial statements and analyse several ratios before investing. Investors often check Return on Capital Employed (ROCE), Return on Investment (ROI), Return on Asset (ROA) and Return on Equity (ROE) to understand how much value for money they would get if they invested in a particular company. But, the interpretation is not as simple as it seems to be. You must know many things before you start analysing a company depending on these ratios. So, let’s dive deep into understanding these financial ratios.

1. Return on Equity (ROE) When a company generates profits, equity shareholders are the last to get paid. The first preference is given to creditors, and then preference shareholders, and so on. Hence, investors need to understand how much value the company creates for them. A high return on equity means the company is generating high profits against shareholders’ capital. But that’s not the case all the time. Let’s understand this with an example. Let’s say you wish to start a salon which will need a capital of Rs 10 lakh. Currently, you have Rs 7 lakh in hand, and you borrow Rs 3 lakh. On this capital, you generate a profit of Rs 30,000. In this case, the ROE generated by your business is profits divided by shareholders’ capital (Rs 30,000/Rs 7 lakh) which comes to 4.28%. On the other hand, if you had borrowed Rs 7 lakh and had only Rs 3 lakh in hand, your ROE would have been (Rs 30,000/Rs 3 lakh), which comes to 10%. Did you just see how debt affects the ROE of a company? High debt can impact the ROE of the company. Let’s also take a real-life example; as of 15th February 2023, the ROE of Godrej Consumer Products Ltd is 17%, and Tata Communications has an ROE of 282%. Does this mean Tata Communications is much better than Godrej Consumer? The answer lies in the debt-to-equity ratio of both companies. Godrej Consumer Products has a debt-to-equity ratio of 0.09, while Tata Communications has a debt-to-equity ratio of 9.74. A high ROE is a result of higher profits, lower capital size of the company or business financed by very high debt compared to capital. Similarly, a share buyback can also spike the ROE of a company because, after a share buyback, the shareholder’s equity reduces, resulting in high ROE. So, investors must scrutinize companies with high ROE to determine whether the high ROE is due to the company’s increased profitability or simply due to its high debt or change in capital structure. Also, you must look for consistency in ROE growth and compare it with the industry’s ROE. Moreover, a high ROE does not guarantee high returns actually for shareholders, as if there is any debt, the creditors hold priority of payments over everyone else.

2. Return on Assets (ROA) A company that uses its assets efficiently can generate better profits, and that’s exactly what we look for while analysing companies. Apart from this, ROA also helps investors analyse the management’s efficiency in managing its assets. Every company has both tangible (land, machinery, cash) and intangible assets (patents, goodwill). But, there is an inverse relationship between ROA and the company’s asset type.

◼️More tangible assets = Low ROA

◼️More intangible assets = High ROA Wondering why?

Let’s simplify. Sectors like steel, refining, and power have high tangible assets. Hence, these sectors must invest a huge part of their revenues in Capital Expenditure (CAPEX), which is why they end up with low ROA. Conversely, IT companies, banks, service sector have high intangible assets. Hence, they don’t have to spend a huge amount on Capital Expenditure (CAPEX), which is why they end up with high ROA. For example, as of 16th February 2023, in the power sector, companies like NTPC, Tata Power, and Adani Transmission have ROA of 4.10%, 2.14% and 2.73%, respectively. On the other hand, in the IT sector, TCS, Infosys and HCL Technologies have a ROA of 28.37%, 19.64%, and 15.35%, respectively. From the above example, we learn that we must not compare the ROA of stocks from different sectors but rather look into the same sector and industry.

3. Return on Capital Employed (ROCE) ROCE helps us understand how much return a company generates for its shareholders. Now, you must be wondering, what Return on Equity (ROE) tells us. Yes, that is true to some extent. ROE is the returns a company generates on its equity capital. So, it does not consider borrowed capital. But ROCE considers debt and gives us a clear picture of the company’s overall returns. It is the profit generated by a company on each rupee of capital employed. So, by analysing ROCE, we understand the returns generated on the total capital employed by the company. As of 16th February 2023,

◼️Nestle has a ROCE of 145.11%. It means that for every Rs 100 of capital employed, the company makes Rs 145.11.

◼️P&G Hygiene has a ROCE of 109.98%. It means that for every Rs 100 of capital employed, the company makes Rs 109.98.

◼️Zomato Ltd has a ROCE of -10.62%. It means that for every Rs 100 of capital employed, the company is losing Rs 10.62.

So, the interpretation of ROCE is just as ROE. Stocks with high ROCE mean the company’s management can generate superior returns for its investors. Now, investors often only look at high ROCE and think that the company is worth investing in. That’s necessarily not true. While analysing ROCE, we must look at ROE and ROA too. Apart from this, here are a few things to follow:

1. As we saw a while ago, ROE is prone to manipulation when there is high debt on the company’s balance sheet. Hence, to analyse capital-intensive sectors like power, refining and telecommunications, ROCE will give you a better picture as it considers debt into the equation.

2. To get a more comprehensive view of the company, you can look at the Return on Invested Capital (ROIC). ROIC is a stricter form of ROCE because while calculating ROCE, we consider a company’s earnings before interest & taxes. But, ROIC is a step ahead of ROCE as it shows the returns generated from its invested capital after paying taxes, interest and depreciation, which is called NOPAT. To conclude, finding a needle from a haystack can be simpler if you carefully analyse stocks using these metrics. To summaries, if a company has zero debt, use ROE as all returns are entitled towards the equity shareholders in absence of creditors. If you are analysing a capital-intensive sector, use ROCE and not ROE, as it takes debt into consideration. Lastly, while analysing these ratios, look at a three or five-year trend, and if you see sudden spikes, investigate the reason behind it. Investing without due diligence is like jumping into a pool without checking the depth! So, before taking the plunge, ensure you’re fully informed.

(Article: The Economic Times)

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