Recently I found myself in the midst of a lively debate with a group of seasoned old friends managing pools of capital. The topic? A classic showdown between folks on the king metric - Return on Equity (ROE) OR Return on Capital Employed (ROCE) ?
What follows is my perspective on these.
First some definitions - ROE is simply the net income over shareholders equity capital. ROCE is Earning before Interest and Taxes (EBIT) over capital employed (i.e. total debt and equity capital). Now, both ROE and ROCE give a perspective on how efficiently is capital being deployed to generate returns , but from different vantage points.
In business, ROCE has been a go-to metric for computation of the efficiency of the capital deployed - that is reflective of the operations of the company. Capital structure engineering should ideally not effect the operational efficiency of the company - and that in financial metrics gets taken into account. In other words, Fund assets through debt or equity - the operations cannot be made more efficient (pause and think deeply about this).
However, as a shareholder ROE possibly is the best metric. For the simple reason that the return on the equity is the funds a shareholder has invested in business and would like to measure the returns. And but of course, one wants a higher ROE. For context, all things being equal, 25% ROE over 10 years is 9x return compared to 15% ROE which would be 4x. Translate this to stock price through P/BV - even if the Price to Book multiple would not expand (which practically should - for a steady 25% ROE company), the returns is more than double (from 4x to 9x of original equity capital invested)!
All things being equal, a higher debt/equity will deliver a higher ROE.
(for delivering a steady ROCE of 20%, the ROE increases with D/E. Done at a tax rate of 25%)
Now the next question is - should ROE be higher than ROCE or lower?
Its a slam dunk - ROE should be higher - since ROCE also reflects the returns to debt capital (and taxes) and should ideally be lower than the return to the shareholder.
Now the surprising (or maybe not so much with some context) part - only 24% of the listed stocks on Indian exchange - NSE, are generating an ROE greater than their ROCE !
Source: NSE
This number ranges from smaller companies which are doing terrible (only 22% generate more ROE than ROCE) to larger companies that do slightly better (30%). I also suspect many of the larger companies with better debt capital access are government owned. Overall, this is reflective of the deleveraging of balance sheets that has happened over the last 7-8 years and still continues.
And amongst other things, this is also an indication of the availability of debt capital today in India.
This situation needs to be remedied. For multiple reasons of growth and making the most of scarce equity capital. And for the benefit of all shareholders, it is of paramount importance to bring in abundant and innovative debt capital to the corporates and mid market firms, and channelize to productive use.
(PS: I’ve got myself a list on large cap stocks delivering a higher ROE than ROCE. And I am invested in them! Let me know in comments if you want that list)
