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Return on Equity
The ultimate financial objective of all companies is to create wealth for their shareholders. Equity investors in a company embark on the highest risk. One cannot assume with any certainty that returns will be generated for them as they earn only residual returns left after the company fulfils all its other financial obligations. In such a scenario, isn't it fair on the part of investors to analyse the company's past returns generated for the equity shareholders before investing in it? One such return metric is return on equity. Return on equity comprises two things. One, the returns generated by the company on the funds raised by the shareholders and second, the returns generated by the company on the reinvested earnings.
Return on equity is calculated as:
ROE= Net income after tax-preferred dividends/ shareholder's equity
In the market, a very popular metric to measure returns is EPS - earnings per share. Why then, do so many analysts prefer RoE vs a simple EPS? Return on equity gives an idea about the profits the company generates from the funds of the shareholders. Higher return on equity is preferred. However, the prospects of a company generating high ROE is also dependent on the proportion of the earnings it decides to reinvest.
If the dividend payout ratio is high, one would normally surmise that the earnings growth rate expected will be less. If a company believes it can make high levels of ROE from new projects, it might prefer to pay out less dividends and deploy most of its profits to fund its projects. If on the other hand, it does not have too many lucrative expansion projects on hand, it may choose to pay out higher dividends to enable the shareholders to invest these funds in a better manner, rather than retaining too much of the profits on the company's balance sheet as idle cash surpluses.
It is for this reason that analysts prefer ROE as a better measure over EPS. If the share capital of a company is small and retained earnings is very large, it is quite possible that even small increases in profits will show up as healthy increases in EPS. However, when one uses the yardstick of ROE, any inefficiency in usage of shareholder funds will become visible, as can be seen from the table below :
In the example above, while EPS has grown by a healthy 20% in 2010 over 2009, a closer inspection of performance reveals that ROE has actually slipped from 18.75% to 18%. This implies that the company is perhaps finding it difficult to deploy the retained earnings as efficiently as it did in the past.
When measuring returns for shareholders, it thus is always a good idea to go beyond the popular EPS number and look at the ROE number as well. ROE is also particularly useful in comparing firms within the same industry. As we will see in the next section, with the same profitability, two firms can produce vastly different ROEs based on their capital structure - and thus reward their shareholders very differently - inspite of producing similar profits.
Return on Capital Employed
Return on capital employed represents the return generated by the company on its total capital employed. ROCE can be shown as:
ROCE= Earnings before interest and taxes/ Total capital employed
Return on capital employed indicates the profitability of the company on both the equity funds as well as debt funds. Ideally, ROCE should be greater than the rate at which the company is borrowing. ROCE implies the efficiency of operations of a management of a company in a holistic manner. It tells us how the management has used the investments in the company to generate profits for the business.
Lets take an example of 3 companies in the same business, which make the same level of operating profit (earnings before interest and taxes). How do you judge which is the best business to invest in?
On a plain EPS metric, it would appear that Company A is the best investment candidate, as it has the highest EPS. However, a closer examination shows that Company C seems a far better bet. Its RoCE is higher as it uses less capital employed to generate the same earnings before interest and tax - ie, operating profit. Its RoE is far higher as it has used much less of shareholder funds and marginally higher borrowed funds to generate returns for its equity shareholders. Equity owners in Company C are enjoying a return of 16.8% on their funds (which is a sum of equity capital invested plus retained earnings) while equity owners of Company A are getting a much less return of only 11.67% on their funds.
Using RoCE and RoE together
RoCE is a good measure to guage operational efficiency of a company - to understand how much operating profit (earnings before interest and tax) a company is able to generate from the total capital employed (shareholder funds plus borrowed funds).
As we saw in the above example, even if RoCE is the same between two companies (Company A and B), RoE is substantially different as the composition to total capital employed is different. When a company is generating a 13.33% return at an operating level and borrows at 10%, it is always profitable for the shareholders to borrow and invest as they get the residual 3.33% for themselves (after paying taxes, of course) without investing any capital of their own. This concept is also known as capital gearing. Company B enjoys a higher RoE than Company A primarily because of this reason.
As we said earlier, Company C seems the best investment candidate as it has a better RoCE (employs less total capital to generate the same operating profit) as well as a better RoE (uses less shareholder funds and higher borrowed funds).
Share your thoughts and perspectives
Do you have any observations or insights or perspectives to share on this issue? Did this help you understand the topic better? Do you disagree with some of the observations? Please post your comments in the box below ..... it's YOUR forum !
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