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ROE vs. ROCE vs. ROIC
(Calculation & Implications)
(Calculation & Implications)
ROE = PBT (1 - t) / Book Value of Equity
t = Tax Rate
Easiest to calculate & most commonly used. Debt might inflate this figure (for a profitabe business). Large cash on balance sheet on the other hand might deflate it.
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t = Tax Rate
Easiest to calculate & most commonly used. Debt might inflate this figure (for a profitabe business). Large cash on balance sheet on the other hand might deflate it.
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This is the primary issue in using ROE. It might also include income from subsidiaries or one off sale of assets. So ROE doesn’t exactly tells you the core profitability of the business.
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“Since I am an 'Equity' investor, 'Return on Equity' is all that matters to me” - No!
You are last in line for payouts.
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You are last in line for payouts.
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ROCE = EBIT(1-t) / Capital Employed
CE = Total Assets - Current Liabilities
Current (non interest bearing) Liabilities are funds that are being provided by others (vendors for example) free of cost and hence they reduce the capital employed & increase profitability.
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CE = Total Assets - Current Liabilities
Current (non interest bearing) Liabilities are funds that are being provided by others (vendors for example) free of cost and hence they reduce the capital employed & increase profitability.
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A negative working capital business is often a good business. ROCE nullifies the impact of leverage or debt. But even ROCE can be depressed by large cash on balance sheet or goodwill.
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ROIC = EBIT(1-t)/ IC
IC
= Fixed assets + Non Cash Working Capital
= Fixed Assets + Non Cash Current Assets - Current Liabilities
= Total Assets - Cash - Goodwill - Current Liabilities
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IC
= Fixed assets + Non Cash Working Capital
= Fixed Assets + Non Cash Current Assets - Current Liabilities
= Total Assets - Cash - Goodwill - Current Liabilities
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This is the holy grail. What you want to know is the ROIC going forward (historical is an indication). A 100% ROIC buiness can generate 100 Rs of cash for 100 Rs of investment.
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When ROIC < WACC, growth destroys value. Although investors claim that eventually on larger size the ROIC will get a bump. Could happen. Has happened. But this “turnaround” is one the most common & tempting traps for new investors. Don’t bet on it.
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The senstivity of Value to ROIC is highest when ROIC is closest to WACC. For 10% WACC, ROIC moving from 10% to 20% has huge impact on Value. ROIC moving form 50% to 100% is not as meaninfgul. For high ROIC business the Value comes from growth.
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If a business has large cash/debt/goodwill on balance sheet, ROIC is the only profitability ratio you should be looking at. (Can't think of a scenario where you would want to look at other two over ROIC except for financials where IC is not defined). Always adjust for tax.
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What you want is:
1. High ROIC business
2. Good management
3. High growth
4. Low multiples
Since often you will have to compromise, it's a good idea not to compromise on the first two (this approach has been taken to an extreme in current markets).
12/12
1. High ROIC business
2. Good management
3. High growth
4. Low multiples
Since often you will have to compromise, it's a good idea not to compromise on the first two (this approach has been taken to an extreme in current markets).
12/12
