Why considering RoCE (Return on Capital Employed) with RoE (Return on Equity) is better????

This post is the extension of one of my previous post on RoE. I discussed about RoE and how debt can show higher RoE and sometimes misleads us.

We have seen that when there is a debt on the books of the company then RoE will show much higher number. Because calculations of RoE not consider debt portion which is there on the book of company. So that we need to check RoCE.

So let’s try to understand RoCE in a simple manner.

What is RoCE (Return on Capital Employed)?

“Return on capital employed (RoCE) is a financial ratio that measures a company’s profitability and the efficiency with which its capital is employed.”

ROCE = Earnings Before Interest and Tax (EBIT) / Capital Employed

“Capital Employed” as shown in the denominator is the sum of shareholders’ equity and debt liabilities; it can be simplified as (Total Assets – Current Liabilities).  – Investopedia

RoCE stands for Return on Capital Employed that means calculating returns on all capital (Equity + Debt) used for generating profits. So RoCE having consideration of debt which is not in RoE calculations.

In calculation of RoE, we took Net profit and shareholders’ equity but for the calculation of RoCE, we took Earnings Before Interest and Tax (EBIT) and Capital Employed (Equity + Debt).

We can see that if we are having debt on our book then RoE (%) shows higher because of not consideration of debt portion. Thus, RoCE (%) also we need to check for getting better understanding.

Debt can magnify returns in good situation but as a when situations start worsening it creates problems. So that company need to take debt very carefully. Generally, we can find that if company having higher RoE (%) compare to RoCE (%) then that because of debt portion.

As debt portion increases on balance sheet then difference between RoE (%) and RoCE (%) also start increasing.

We always focus on higher RoE (%) but with that also we need to check debt level and RoCE (%) so that we can able to get better understanding about the business situations. If RoE (%) magnify due to higher level of debt then we must have to be careful because debt always help in favorable situations and as a situation starts worsening, debt first in queue for giving pain.

Not only RoE (%) or RoCE (%) help us, we need to check both together. Sometimes RoCE (%) shows positive return but due to higher debt and worsening situations RoE (%) give us a prior signal. And as RoE (%) is lower compared RoCE (%) then we can say that company facing problem due to debt burden. When RoCE (%) falls below interest rate (%) from then problems for the company starts arising.

 

Bonus

We need to check both RoE (%) and RoCE (%) together because sometimes RoE (%) provide us a prior signal of worst situations and sometimes RoCE (%) help us to protect us from getting attracted towards higher RoE (%). And never gets attracted with higher RoE (%) that can mislead us sometimes.

Learning investment lessons from movie “Rajneeti”

I again watched one of my favorite movie “Rajneeti” (Politics) and this time I get idea to connect this movie with an investments lesson. So I try to explain some of the lessons which I learn from movie in a simple manner. Lesson may or may not be as per the story timeline.

• Clear with objective

In movie, Arjun Rampal (Prithviraj Pratap), Manoj Bajpayee (Veerendra Pratap) and Ajay Devgan (Sooraj Kumar) having clear objective of winning election. As same we must have to be clear with our investment objective. Many of us doesn’t have any objective for making an investment and also many of us not clear with making an investment or doing trading.

Both investment and trading needs different psychology so that its extremely difficult to handle both simultaneously.   Thus, we have clear with making an investment or doing trading and what is the objective for making an investment.

• Future is unforeseen and uncertain so never make much more expectations from future

At the time of election, president of political party faced severe heart attack,  Murdered of new president, At the last phase of election, Arjun Rampal got killed who having better chance of winning election respectively.

These above all incidents teach us that future is highly uncertain and unforeseen. We ever never know about the future. So we should focus on what currently we have rather focus on future story. That story may or may not be true but on the basis of that story we should not get over optimistic or over pessimistic. Ex: – GST will clear and that benefits to many sectors but that may or may not be get clear. Based on such uncertain events we make many investment positions and if not get clearance then investment get fail. So rather focusing on such events need to make an investment in such a company which have shown growth, not depend on GST and if GST get clearance then that will be work as bonus for business. Thus, we have to keep ready for any of the situations.

• Always remain calm & cool; never be fall in trap of aggression

My favorite characters from movie are Ranbir Kapoor (Samar Pratap) and Nana Patekar (Brij Gopal) who always seem to be calm & cool in any of the situations. Never get aggressive in any of the situations. From starting to end, they execute their every strategy with good control on temperament.

And on other side, Arjun Rampal (Prithviraj Pratap) has invited many troublesome situations with fall in trap of aggression and losing control on temperament.

So as same we also need to be remain calm and cool in every market condition. Either condition can be favorable or unfavorable. As we lose control from our temperament, we start inviting troublesome situations. In aggression, sometimes we can make an investment which we should not need to make. After making decision, we have to suffer a lot. The situation will not be going to change as we make changes our metal status and rather situation become more worst. Thus, we should make any decision, in any situation with remain calm and cool.

• Always focus and trust on our decision and not get disturb with noises

In movie, Ranbir Kapoor (Samar Pratap) and Nana Patekar (Brij Gopal) are very clear with their decision, strategies and ideas. They don’t have doubt on their own decisions; also not make changes or get disturb with outside noise.

When Ranbir Kapoor ask to Arjun Rampal for putting resignation from post of party president then he not get disturb with arguments from Arjun Rampal and remain stick with original strategy.

As the same, we also have to focus and trust on our decision rather to focus on prevailing noise. As when we start focusing on noise then our decisions will not remain stronger; we start creating doubt on our decisions. One unreliable noise can influence us to change our decision and that will bring us in a miserable situation.

• Need to change our strategy as our assumptions get change

We have seen in movie that whenever original assumptions get change, Ranbir Kapoor and Nana Patekar has make changes in their strategy.

As Ranbir Kapoor has seen that assumption of getting party fund by getting married with Katrina Kaif looks like failure then he makes changes in his strategies.

So as the same whenever our original assumptions of investment decision get change then immediately we have to make changes in our strategy. We must have to be remain dynamic to be change with changing environment and assumptions.  Then and only then we can able to survive and also able to get decent returns from our investment.

• Focus on sharpening our skill, luck can come to our door any a time

In movie, Ajay Devgan has sharpen his skill like to be a strong, smart and strategist but luck has supported him to become a member of core committee of political party. So if he has not skill then luck also can’t able to help him.

Luck and Opportunity never knock at our door frequently. So we must have to be ready with sharpening our skill. We don’t know when market provides us an opportunity and at that time if we don’t have a particular skill then that we have to lose lucky moment.

• Successful are not those who only appear on public platform & on media

We have seen in movie that Ranbir Kapoor has worked as a backbone of Arjun Rampal. He never comes to public platform. But he was the real strategist. He helps his party for winning election by making good strategies. As real successful person need to consider as Ranbir Kapoor not Arjun Rampal.

So that it’s not necessary that those who appears on public platform and on media, they only are successful. There are many investors who never or rarely comes on public platform and they are really very successful investors. We generally get biased with to whom we see regularly on media, they are only successful. So we need to learn to do our work silently and getting close to our goal.

• Always remain humble

In movie at last, Nana Patekar again provide job to father of Ajay Devgan. Though Ajay has created many worst situations for Nana Patekar & family.

We never have to forget that our success not only because of our skill, there is a part of luck. That help us for remain humble forever. Everything work as a pendulum, so that we never have to be egoistic whenever getting good returns on our investment.

Bonus

Nature and surrounding environment provide us an ample opportunity to learn and understand. So we just need to think and see the whole world with the learning attitude.

Watch movie “Rajneeti” for better understanding above article.