Staring at the financial statement for hours will not help you pick the best stocks. In fact, it is like looking at a 1000 page literature book without making an attempt to understand it. You need to start reading it in both cases. Just like alphabets, ratios aid you in your process of understanding financial health, risk, growth, and various other important metrics pertaining to the company. So if you are keen on picking up the right stocks, then the usage of ratio analysis becomes pivotal.
While there are plenty of ratios that might help you in grabbing the right cash cows, we will be diverting our focus towards two important ratios. These ratios are quite confusing and are mostly used wrongly or interchangeably. They are,
- Return on equity (ROE) and,
- Return on capital employed (ROCE).
Return on Equity (RoE)
ROE or Return on equity gauges the company's efficiency in putting the assets into use and generating income out of it. It also helps both existing and potential shareholders find out whether or not the company is using shareholders' money in a good way. ROE is also used in estimating growth rates or possible dividend rates. This is done by studying the historical data of the company. The formula for calculating ROE is as follows,
Return on equity = Net income/ Shareholders equity
Source: Stock Analysis by Ticker
For instance, assume a company makes 250000 as it's income. And shareholder's equity, which includes debt and equity, is 5000. Then the ROE will stand at 50%. This ultimately translates that the stock might be a good buy.
Usually, a higher ROE is preferred. Because it means that the company has a steady financial model capable of putting the assets into good use; also, Return on equity can be interpreted most accurately only when compared among the companies in the same industry. And the benchmark may also vary from industry to industry.
But sometimes a higher ROE can be grave if not interpreted in the right way. A few cases where ROE can be misleading are as follows,
- Decreasing or falling equity investments can hype the Return on equity. The shareholders might be withdrawing their stake due to the poor performance of the business. But this might affect the shareholder's equity and automatically show a higher ROE.
- If the company has been seeing a series of losses, then the shareholder equity would have been impacted already. In that case, if it reports a sudden hike in profit, its ROE will be higher. Ensure that you don't fall for it until the company deems to be a worthy pick.
- A company may need cash for various day-to-day operations. In such a case, it may borrow some funds. This might increase the ROE. If you are buying the stock based on such a hype, then you are in trouble.
- When both the company's income and the shareholders equity is negative, its ROE can be projected huge. You might check this as well and not blindly put your money into them.
- When a company makes new investments in the form of new machinery or plant, its ROE might be well below the expected benchmark. But note that this can be a temporary issue. This does not translate that the company's performance is not up to the mark. Hence it's crucial for you to look behind the numbers and find out as to why the company is lacking behind.
Hence a higher ROE does not necessarily mean a good performance and vice versa. Every investor should always try to track the reason behind each and every number rather than blindly believing them. While the ROE metric helps one in understanding various aspects of a business, it also carries a certain drawback. The following are the arguments that analysts place against it.
- The inner management circle of the company can easily have their hands on the accounts and manipulate it.
- ROE calculation only covers the tangible accounts or tangible items of a company and leaves intangible items entirely out of the equation.
Have you read our previous Master Class: How to analyze and value Banking Stocks?
Return on capital employed
Capital forms the base of any business. As an investor, you will want to know how efficiently your company is using its capital; that is where the ROCE will assist you. ROCE, or Return on capital employed, explains to you how the capital of the company is used in churning out profits. It offers long term visibility. That is why most analysts prefer this over ROE
ROCE = EBIT / Capital employed
Source: Stock Analysis by Ticker
So let EBIT be 40000 and capital employed be approximately 10000. Then the result would be a 40% ROCE. That means the rupee which you invested is fetching you a 40% return.
EBIT means earnings before interest and tax. The operating profit of the company can also be used here. Capital employed includes the assets of the company. Cash in hand is usually excluded in terms of ROCE as it isn't yet employed in the business operations.
This ratio is a wonderful comparison metric if you are planning on purchasing stocks of those industries, which are capital intensive like telecommunication, steel production, etc. Unlike ROE, which only takes into account the equity of a firm, Return on capital employed considers both the equity and debt portion of the company.
Always compare the historical trends and also make a peer-to-peer study. As an investor, it is always advisable to go with companies having an increasing or steady trend. Such a trend will mean that the company has a good cash flow. Note that two companies that are similar in terms of earnings or profit made can vary in their ROCE. This is also used by internal management. They can forecast the enterprise's future growth and know the details as to how their capital is working. The borrowing rate should always be less than the Return on the capital employed rate. Only then can the company be considered as one making profits. Or otherwise, it might end up making a loss. So look at the borrowing rate of its debt as well.
Understanding the difference: ROE vs. ROCE
There's often a confusion between ROCE and ROE, as both the ratios help in the evaluation of returns generated from equity and capital. The following table demonstrates the few but significant differences between both the ratios.
ROE vs. ROCE
Hoping you are well aware of both ratios' pros, cons, and usage, let's move onto the action part now. All you have to do is start implementing them in order to pocket some good returns. Because it is a proven mantra that out of the 100 people who learn something new, only 10 of them will put into practice. So which category are you going to join? The doers or forgetters? And have a quick look at this as well: YouTube
To understand more checkout the next blog: Price to Growth (PEG) Ratio
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