19. The Difference Between Return on Equity and Return on Capital¶
Return on equity (ROE) and return on capital (ROC) measure very similar concepts, but with a slight difference in the underlying formulas. Both measures are used to decipher the profitability of a company based on the money it had to work with.
19.1. Return on Equity¶
Return on equity measures a company’s profit as a percentage of the combined total worth of all ownership interests in the company. For example, if a company’s profit equals $10 million for a period, and the total value of the shareholders’ equity interests in the company equals $100 million, the return on equity would equal 10% ($10 million divided by $100 million).
The formula for calculating ROE is as follows:
Return on equity = Net income / Average shareholders’ equity
There are a number of different figures from the income statement and balance sheet that a person could use to get a slightly different ROE. A common method is to take net income from the income statement and divide it by total shareholders equity on the balance sheet.
If a company had a net income of $50,000 on the income statement in a given year and recorded total shareholders equity of $100,000 on the balance sheet in that same year, then the ROE is 50%. Some top companies routinely have an ROE north of 30%.
19.2. Return on Capital¶
Return on capital, in addition to using the value of ownership interests in a company, also includes the total value of debts owed by the company in the form of loans and bonds.
For example, if a company’s profit equals $10 million for a period, and the total value of the shareholders’ equity interests in the company equals $100 million, and debts equal $100 million, the return on capital equals 5% ($10 million divided by $200 million).
The formula for calculating ROC is as follows:
Return on capital = Net income / Debt + Equity
As with ROE, an investor could use various figures from the balance sheet and income statement to get slightly different variations of ROC. Ultimately what matters is that the investor uses the same calculation over time, as this will reveal whether the company is improving, staying the same, or declining in performance over time.
If a company had a net income of 50,000 on the income statement in a given year, recorded total shareholders equity of 100,000 on the balance sheet in that same year, and had total debts of 65,000, then the ROC is 30% (50,000 / 165,000). This is a very quick way to calculate ROC, but only for very simple companies. If a company has lease obligations this too needs to be factored in. If a company has one time gains which aren’t useful for comparing the ratio year-to-year, then these would need to be deducted. For additional ways of calculating ROC, see Return on Invested Capital.
ROC and ROE are well-known and trusted benchmarks used by investors and institutions to decide between competing investment options. All other things being equal, most seasoned investors would choose to invest in a company with a higher ROE and ROC when compared to a company with lower ratios.