Return on Equity (ROE) and Return on Capital Employed (ROCE) are popular ratios for gauging a company’s financial quality.
The measures try to assess how efficient and productive a company is with its money.
The higher the ROE or ROCE, the better, as less funds from shareholders — in theory at least — are required to generate greater profits.
A major difference between the two ratios concerns debt. ROE takes it into account (earnings are calculated less interest and shareholders’ funds are calculated less all borrowings), while ROCE effectively excludes it. The latter therefore tries to highlight companies producing generous returns through attractive operational assets but without the aid of financial gearing.
Investors have long debated the pros and cons of the two ratios, prompting all sorts of alternative hybrid measures to be developed over time. For many investors, ROE is the favourite. At the end of the day, everything boils down to how much money attributable to shareholders (i.e. earnings) can be generated on the money supplied by shareholders. Generally speaking, a ROE of 15% or over is worthy of further investigation.
Formulae
The formulae are shown below:
Earnings
Return on equity (%) = -------------------
Shareholders' funds
Operating profit
Return on capital employed (%) = ----------------------------------------
Shareholders' funds + debt (and similar)
The denominator in both calculations can be the year-end figures or, preferably, an average based on the year-start and year-end numbers.
Apply with care
As always with investment ratios, care has to be taken with the calculation of ROE and ROCE. There are two important factors to bear in mind.
1. Goodwill: Purchased goodwill and intangibles create no end of problems for ROE/ROCE calculations. Prior to the 1998, purchased goodwill was written off directly to reserves and thus allowed significant expenditure to disappear into the accounting ether. Goodwill is now capitalised on the balance sheet and amortised over (usually) twenty years.
To cut a long bookkeeping story short, goodwill previously written off or amortised ought to be added back to a company’s equity/capital employed figure to provide a realistic ROE/ROCE value. With less time to bring the acquisition up to speed, recent goodwill additions can depress the latest ROE/ROCE calculations.
2. Write offs and exceptional items: Two more ROE/ROCE troublemakers. They may be excluded from underlying earnings and are sometimes non-cash charges, but write offs and exceptional items are a true economic cost to shareholders and can’t really be ignored.
For the calculations, investors should add back asset write offs to the equity/capital employed denominator. The philosophy with exceptional items is a little trickier (as they don’t always relate to balance sheet items), but adding these back to the denominator is better than ignoring them.
Nuances
Accompanying those two issues are three more accounting nuances.
1. Revaluations: Asset revaluations increase the worth of a balance sheet but have no impact on reported profits. As such, they can unfairly depress ROE/ROCE ratios when in fact the company has actually made some canny investment decisions.
Of course, the flipside to revaluations are old assets that are in the books for next to nothing. These could flatter past ROE/ROCE figures when, in actual fact, substantial expenditure will be required for future replacements/additions.
2. Non-trading assets: Cash piles, investments and associate holdings (and the relevant income) are sometimes excluded from ROE/ROCE calculations on the grounds they aren’t part of a company’s core operation. But an asset must be held for a reason, no matter what type of profit it generates, and they still benefit shareholders in real life. To paraphrase Bill Shankly: “If an asset is not interfering with trading or seeking to gain an advantage, then it should be.”
3. Provisions and minorities: A provision is (arduously) defined as ‘an amount retained to provide for a liability or loss which is either likely to be incurred, or certain to be incurred but uncertain as to the amount or as to the date on which it will arise‘. The amount is deemed a liability on the balance sheet, though the company in practice still benefits from the cash set aside. As such, provisions ought to be added back to the ROE/ROCE denominator.
Minority interests occur when a parent company has one or more controlled subsidiaries that are not wholly owned. The after-tax profits and assets associated with minority shareholders are disclosed in the main financial statements and should be excluded from the ‘majority’ shareholders’ ROE ratio. But the idiosyncrasies of accounting mean minority interests aren’t revealed at the operating profit level, nor itemised on the balance sheet, so ROCE fans will have to do some guesswork.
Summary
ROE and ROCE are pretty good indicators of superior businesses, but numerous accounting issues make them far from perfect. The incremental return on equity calculation tries to iron out some of the problems, but it can develop into a statistical nightmare even faster.
Still, broadbrush calculations will often suffice, with companies that have consistently reported high ROE/ROCE ratios making good starting points for further research. Remember, though, that past accounts will never answer the key investment question: whether or not the good returns of the past will continue well into the future.
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