This is a part of the Investing Series.
Warren Buffett is a legendary investor, and he uses these two particular metrics to take a look at a company as a quick overview:
Return on Equity (ROE) and Return on Capital Employed (ROCE)
WHAT IS RETURN ON EQUITY?
Return on equity just means how much the company makes as a net profit that can be divided by the equity shareholders have in the company.
It’s important as a metric versus just looking at how much money is being generated by a company each year, because you can use it to see how the company manages its money even taking into account previous years’ savings, such as in retained earnings.
This is important to know how they’re managing their savings because you can quickly see how well a company is managed in terms of deploying their money into assets and other ventures to turn a net profit, which in turn, you as a shareholder will benefit from.
WHAT IS RETURN ON CAPITAL EMPLOYED?
Same idea as ROE but it’s a company’s earnings before interest and tax deductions (EBIT = Earnings before Interest and Taxes), divided by its total assets minus current liabilities also known as Capital Employed.
It’s basically how hard their money is working for them based on how much they have invested as assets into the company.
WHAT ARE CURRENT LIABILITIES?
Current liabilities are debts that are due within a year, such as accounts payable, or other bills.
For instance, your credit card is a current liability, as it is due within the month. So are your housing taxes, or your car loans.
HOW TO CALCULATE RETURN ON EQUITY
ROE = Net Profit / Shareholder’s Equity
You would use the net profit from the past 12 months, and the shareholder’s equity figures from the most recent 5 quarters (not 12 months, 15 months!)
This can all get unwieldy, so I’m going to make up a simpler example to get you to see how it works.
Imagine as a new graduate, your bank account was $0, but you desperately needed to be outfitted for interviews and for work, so your parents gave you $500 to go get a new work wardrobe.
This $500 makes them “shareholders”, or investors in your career (so that you’ll pay them back some day!!).
(Let’s assume you don’t pay back your parents until after the first year of working.)
Now imagine that with that $500, you got all the clothes you needed, and landed a great $50,000 a year job.
As a result at the end of the year, you have about $10,000 as your net savings after paying for taxes, your living expenses, food, debt servicing, and so on.
Your parents’ ROE would be $10,000 (your net savings or “net profits”) divided by $500 (their shareholder’s equity, or the amount invested in your career).
$10,000 / $500 = 20
This is good! It means that for every dollar your parents invested, it returned $20.
Of course.. these are unheard of ratios in the real world, but nevertheless I hope you get the idea.
HOW TO READ AN ROE
- Less than 10% = Bad
- 11% – 16% = Meh
- 17% – 18% = Very Good
- 20%+ = Excellent
A high ROE means the company is doing well, and using the money of their shareholders really well, but an ROE that is going down, means that they’re not able to sustain enough net profit (not necessarily earnings) to earn more each quarter.
A ROE that is holding steady may just mean it’s in a niche, but is doing well to keep it up year over year.
You’d also want to check a company’s ROE against other competitors in the industry to see if they are in-line or not, and to give you an idea if an ROE of a company is declining, steady, or on the rise.
KEY RATIO TO USE WITH ROE: DEBT TO EQUITY
If you are also looking at an ROE, you might want to take a look at the debit to equity ratio.
Much like a person who drives around in a car they can’t afford, if a company is using a lot of debt to make itself look good, they will be the first to fall when the economy starts to tank.
If they have more debt than equity.. well, it might be time to take a closer look.
HOW TO CALCULATE RETURN ON CAPITAL EMPLOYED
ROCE = Net Operating Profit [EBIT] / Capital Employed
HOW IS CAPITAL EMPLOYED CALCULATED?
It’s like a calculation within a calculation!
There are actually two ways to get capital employed, but I am going to use the easy one, which is:
Total Assets – Current Liabilities = Capital Employed
So taking the same example above and putting it altogether!
Let’s say your parents asked you to pay back their $500 within ONE YEAR, making it a Current Liability, then it would look like this:
- Your Savings before Income Taxes & Interest = $20,000 (also known as EBIT)*
- Your Parents’ Investment = $500 (also known as Current Liabilities due within 1 year)
- Your Assets = $5000 (let’s say you have $5000 worth of stuff, also known as Total Assets)
*I made it slightly higher because I added back our fictitious taxes and interest.
$20,000 / ($5000 – $500) = 4.44
THE THING TO REMEMBER ABOUT ROCE
A great ROCE should always be higher than a company borrowing money because the more money a company borrows, the less the shareholders earn.
SO WHERE DOES BUFFETT COME IN TO ALL OF THIS?
In his ideal world, ROE = ROCE.
That means if ROE = 20, and ROCE = 20, he’s interested in the company because it means they’re really using their money and assets efficiently to turn a profit for shareholders.
That means if your ROE in our example above = 20, and your ROCE = 4.44, Buffett would not want to really invest in your career.
However if you managed to get an EBIT of $90,000 instead of $20,000 he might be interested in you, seeing as your ROCE would end up as a 20, which would match perfectly with your ROE.
- ROE = Return on Equity
- ROCE = Return on Capital Employed
- ROE means how well a company is managed to deliver net profits to shareholders
- ROCE means how well a company uses its assets to deliver net profits to shareholders
- Warren Buffett likes companies that have equal ratios: ROE = ROCE