You must have come across these words when you must have opened a business channel [CNBC or Zee Business] while trying to understand the stock markets and half an hour later you must have closed your TV. Lol! happened with me also at very first time. These dalal street guys will make things look complicated while actually they are not to be honest!! So Lets start.
ROE(Return On Equity)
For understanding this term ROE you must first understand what is EQUITY.
Suppose you wanted to open a company of Rs 100. You invested this amount,So you will be having 100% stake of your company.Now If you took Rs 50 from your friend and invested Rs 50 and opened a company worth around Rs 100 so you have to give 50% stake of your company to your friend.
This stake is known as EQUITY. .
Now How much money you made on this amount(Rs 100) is know was Return On Equity. Now in financial terms it is calculated the formula [Net Profit/Share capital + Reserve]
ROCE(Return On Captial Employed)
Now return on capital employed is actually Equity + Debt taken. So formula for this one is [Operating Profit/share captial+borrowings]. Lets take the same example.
Here You want to open a company of worth Rs 100 but you have only Rs 50 with you. So what you do is you take this Rs 50 from a friend with an interest to pay but didn’t gave a stake in your company for that. So this Rs 50 will be the debt. Now the total amount is Rs 100 but here the difference is you have 100% EQUITY of you company . The formula here becomes [operating profit/share captial + borrowings]. Now why we take operating profit instead net profit is because in net profit we already deduct the amount to be paid as interest for the debt the company has taken so this is wrong right! First let me earn from the overall money I got from [equity + debt] capital employed then I will pay the expenses because overall we have to find how well the company managed the money.
ROE VS ROCE [ Which One We Should Use And Why?]
When the company is debt free you should go for ROE but when the company has debt over it you should go with ROCE. Now I will tell why? lets take an example
Suppose company A invested Rs 100 in its company and took a loan of Rs 100 from a bank and earned around Rs 100 overall. So What will be the ROCE. It will be around 50% right! ROCE is considered as profit from both equity+debt but what about ROE
ROE is considered as Return from the equity.What was our equity – Rs 100 right! and we made a profit of Rs 100 so what will be our return ROE. Yes you guessed it right!.It will be 100%. From 50 to 100 and this is how company will try to make you fool by this method. So whenever you are analyzing the data of the company and the company has debt over it you look for ROCE as it will give you right information about the company. Here Are two companies in which one has Debt over it and one is debt free
Now you must be thinking if ROCE is equity+debt then Hindustan Unilever should have same ROE and ROCE. Remember I told the formula for ROCE we take operating profit over there rather than net profit and you know the reason why we are taking that!!
So if a company has a good margin of ROE should I invest in that ! Wait hold on there is catch here .I told the formula of ROE that is [Net Profit/share captial+Reserves].
So here Share captial – amount invested from equity and Reserves are amount you keep as cash when you earn profit. But what if the company stake holder who has 100% stake in the company takes the profit(Reserves) and gives it to himself as form of dividend.[Dividend – Some part of the company’s profit is given to the company’ stake holders like if I have 100 shares of Infosys and company announces Rs 8 dividend so me as a share holder will get Rs 800].So here as the person has 100% stake hold of the company so he will get all the money from the reserves. So here what he is trying to do is he is making Reserves as zero[ just like the example in ROCE ] and calculating ROE By [netprofit/share captial] which will inturn increase the ROE. So when the company has zero debt look for ROE and dividend yield – which should not be more [Like company should not try to reduce the reserves by paying out more dividend]
Summary : Debt Free Company – Roe and low dividend
Company having Dept – ROCE