A firm should earn an ROE which is higher than its ROC to make its stock worth buying
While assessing the economic attractiveness of a target stock, young equity investors must ensure that the target firm earns an ROE which is higher than that of its ROC.
Return on Equity is one of the important measures of the financial performance of a firm for its equity shareholders. Let us look at the relationship between Return on Equity (ROE) and Return on Capital (ROC).
Let us look at Dipankar Ltd’s (DL) financials for its latest financial year: Earnings before interest and tax (EBIT) Rs 1,200 crore; net income Rs 600 crore; shareholders fund Rs 2,500 crore; total assets Rs 6,000 crore; current liabilities Rs 1,500 crore. The firm does not have interest bearing short term debt and the long term debt outstanding is Rs 2,000 crore (to be repaid after five years in full) with an interest rate of 10% and applicable tax rate for the firm is 40%.
Return on Capital (ROC) The ROC is computed by dividing the after-tax EBIT by the invested capital figure. After-tax EBIT for DL is Rs 720 crore. Invested Capital is Rs 4,500 crore (i.e total asset minus total current liabilities, so Rs 6,000 crore minus Rs 1,500 crore). Invested capital could also be computed as the sum of shareholders’ funds and long-term debt (for DL it is Rs 2500 crore plus Rs 2,000 crore). Hence, ROC for DL is 16% (Rs 720 crore / Rs 4,500 crore *100). This indicates that DL earns Rs 16 as ROC for every Rs 100 as invested capital.
Deriving ROE from ROC In fact, ROE could be computed as the sum of ROC and the excess of ROC over debt-equity times after-tax interest. For DL, ROC is 16%. Interest rate is 10%. After-tax interest rate is 6% i.e 10 (1-0.40). Debt equity ratio of DL is 0.80 times i.e., debt/ equity (2,000/2,500 crore). Hence ROE for DL is = ROC + [ (ROC- After tax interest rate) * D/E] = 24% (16 %+ [(16%-6%) *0.80]. if we compute ROE for DL directly by dividing net income by its shareholders’ funds, we get the same 24% (Net income / shareholders’ funds *100 = (1200-200) (1-0.40) / 2500 *100 ).
Takeaway for young equity investors While assessing the economic attractiveness of a target stock, young equity investors must ensure that the target firm earns an ROE which is higher than that of its ROC. If the target firm’s ROE is less than its ROC, then it indicates that the firm is unable to earn sufficient return on its invested capital to pay its after-tax interest costs on borrowing. Therefore, one of the ways to find out the quality of investments made by a firm is to put it to the ROE minus ROC test. Dl passes this test as its ROC (16%) is higher than its after-tax interest rate of 6%.
The writer is associate professor of Finance at XLRI – Xavier School of Management, Jamshedpur