Return on Equity (ROE)
ROE measures how much profit a company generates for every rupee of shareholders' equity (net worth). It answers: "How efficiently is management using shareholder capital?"
- ROE = Net Profit (PAT) / Shareholders' Equity × 100
Example: Company A has PAT of ₹100 crore and shareholders' equity of ₹500 crore → ROE = 20%.
A consistently high ROE (15%+) over 5–10 years suggests a business with competitive advantages (moats) — like strong brands, network effects, or cost advantages that allow superior returns.
Warren Buffett's first filter for any investment: ROE consistently above 15% without excessive leverage.
What "Without Excessive Leverage" Means
The DuPont formula breaks ROE into three components:
- ROE = Net Profit Margin × Asset Turnover × Financial Leverage
- or equivalently: ROE = (PAT/Sales) × (Sales/Assets) × (Assets/Equity)
A company can boost ROE by taking on more debt (financial leverage). This makes ROE misleading for leveraged businesses. A bank or NBFC with 20% ROE funded mostly by deposits (effectively debt) cannot be compared directly to a software company with 20% ROE and zero debt. Always check the debt-to-equity ratio alongside ROE.
Return on Capital Employed (ROCE)
ROCE measures return on all capital used — both equity and debt. It is a better measure for capital-intensive businesses (manufacturing, infrastructure, telecom) where debt funding is common.
- ROCE = EBIT / Capital Employed × 100
- Capital Employed = Total Assets − Current Liabilities, or equivalently, Shareholders' Equity + Long-term Debt
Example: EBIT ₹200 crore, Equity ₹500 crore, Long-term Debt ₹300 crore → Capital Employed = ₹800 crore → ROCE = 25%.
When to Use ROE vs ROCE
- Use ROCE for capital-intensive sectors: manufacturing, power, infrastructure, cement, metals, telecom. These businesses inherently carry debt to fund assets.
- Use ROE for asset-light businesses: software, consumer brands, hospitals, financial services (with caution on leverage).
- ROCE > Cost of Capital (WACC) means the business is creating value. If ROCE is below cost of capital, the business is destroying shareholder value even if PAT is positive.
Indian Sector Benchmarks (Approximate)
- IT Services: ROE 20–40%, ROCE 25–45% (high asset-light returns)
- FMCG: ROE 30–60%, ROCE 35–60% (iconic consumer brands)
- Pharmaceuticals: ROE 15–25%, ROCE 15–25%
- Cement: ROE 12–20%, ROCE 12–18%
- Banks: ROE 12–20% (leverage makes ROCE irrelevant for banks; use ROA instead)
- Steel: ROE 8–20% (cyclical, varies widely)
Red Flags in ROE/ROCE Analysis
- ROE declining for 3+ consecutive years: Eroding competitive advantage
- High ROE but very low ROCE: Company funded by high debt — dangerous
- One-time exceptional items boosting PAT: Adjustments needed for true ROE
- Goodwill from acquisitions inflating assets: Reduces apparent ROCE if goodwill is large