1) Generally the best way to compute ROCE is by taking average capital employed or average Shareholder funds (equity + Reserves)

This "average" is determined by opening + 1/2 of current year's profit (for RoE) or PBDIT (for RoCE) as the case may be. But whether you do it on opening or average basis the difference is generally very small so in most cases it does not matter unless you are documenting your data.

3) Yes.

3) Preference dividend is deducted from RoE the easiest way to compute RoE is EPS/Book Value. That is why I say the more the book value the less the chances of a higher RoE

4) Should be 1, less then that is cheaper and more then that costly.

5) To get a broad first hand view we do it with sales because that is toughest to fudge but to calculate equity value EPS growth has to be seen.

I see a flaw in the formula. actually, EPS is not your actual cash income. Inspite of your paying 100 p.c. out of your EPS, you have a cash surplus( note, their are items which reduce your EPS, but doesnt lead to cash outflows, like depreciation). This surplus, if employed for income generating assets liek bonds or MF increases your other income in the subsequent years.But, then there is no change capital employed and is a constant. So, net result is ROCE goes up.

Actually, Mr. Basant its not just the ROCE thats important.Its the slope of the ROCE curve(if that be plotted on graph with ROCE on x-axis and year in the y-axis), thats important. Actually, the points of inflexion on the ROCE curve shows growth, stagnation or decline.The same goes for the EPS as well.see, as an investor I look for 2 things:

Does P/E Matter?

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite—that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find . . .”- Warren Buffett

One morning, a friend came to me and said, “ You have to buy this stock, it is trading at a P/E of only ten times this year's earnings, and everything else in the sector is over 20 times! It is also growing a rate of 20%, thus PEG is 1/2”.

I was stumped. I asked, “ How did you arrive at the calculation?”

My friend said, “ I just read a report of a prominent brokerage house that has given a buy on this stock, based on its low P/E multiple and high growth rate compared to its peers.”

I retorted, “If the investing funda was so simple then we all would be very very rich. You are hoping this stock somehow wakes up one day, realizes it doesn't get the same respect as its peers, and starts to go up. I have analysed the company. Its return on capital (ROIC, Please refer to the end of the article for detailed defination of ROIC) is less than its cost of capital. Thus with high growth it is only destroying shareholders value faster”.

That meeting is still fresh in my mind to this day. It serves as a reminder about how the valuation metrics used by most of the analysts are inadequate in projecting stock price movements. It has also taught me the ultimate importance of defining in clear terms what edge does the company have over others.

P/E multiple is the most used and the most abused multiple in the investment world. It is generally believed that company with high growth rates will have high multiples and vice versa and if one finds a stock with high growth but low P/E than it’s a good buy. But what we fail to appreciate is the important role that returns on capital (ROIC) play in channelling growth into a high or low multiple. It's common sense: growth requires investment, and if the investment doesn't yield an adequate return over the cost of capital, it won't create shareholder value. That means no boost to share price and no increase in the P/E multiple.

To illustrate, most Retail companies, like Pantaloon, are witnessing high growth. To give high P/E multiples to retail companies just because of their high growth is misleading, as it doesn't take into account returns on capital (ROIC). Retail companies fight it out primarily on price, which translates into lower margins and relatively low returns on capital. Such high P/Es, based on the high growth rate of the company, will not be sustainable.

To demonstrate the relationship between Growth, ROIC & P/E, Michael Mauboussin, CIO of Legg Mason Capital Management, developed a grid describing growth and return for a theoretical company. The grid clearly proves that P/E is determined by both ROIC & growth. The table is shown below: -

ROIC and P/E Multiples: Theory

                           NM = not meaningful.

                           Note: Assumes all equity financed; 8 percent WACC; 20-year

                                   forecast period.

                           Source: LMCM analysis.

Thus we see that it is both growth and ROIC that determines whether company will create or destroy value. We as investors should look for the rare company that can combine high growth with high returns on capital.

We should remember that we should not avoid stocks just because it has a high multiple relative to peers or buy a stock with high growth but low P/E multiple. We should try and understand the complex chemistry of growth, return on invested capital, and P/E multiples while making investment decision.

To summarize, we see that P/E and company’s investment success or failure will be determined by:

=     Growth rate of the company

=     The magnitude of capital required to sustain the growth

=     The spread between the return on capital and the cost of capital and how long a company can deploy capital at positive spreads

Views expressed in the article are personal and does not represent that of the company where the author is working. This article is for information only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. This article was written for valuenotes.com. Comments and suggestions are invited at mailto:[email protected] - [email protected]

 Please Note the defination of ROIC:

Good discussion. I really enjoyed both of them. Both are correct. RoCE is good taraju.

ROCE= operating profit/ capital employed

what i conclude is if the company is growing, though it might be profit making, but because of expansion capex, the cash flow may be -ve currently. Nothing to bother....plz correct me if i am wrong.

Wall Street is fixated on the earnings number of a business. In the short run, stock prices are very sensitive to a company’s earning achievements.

Earnings Are Not Alone

While profits are essential, understanding how they fit into the value creation process is critical. This is where return on equity comes into play.

An initial yet meaningful way of looking at return on equity is similar to a coupon on a bond. A bond that earns a higher coupon yield than the prevailing rate of interest will trade at a premium, or above its par issued price. A bond that is issued paying ten percent a year will be worth more in the future if future rates on interest have declined. The reason is simple economics: no investor will pay the same price for an eight percent bond if he or she can buy a ten percent bond for the same price. So the price of the existing ten percent bonds will increase until its new market price represents an approximate eight percent effective yield. So if the bond had a face value of $1000 and initially paid $100 a year, its new price would be $1250 because at an annual payment of $100, the return is 8 percent.

Similar to a bond in a fundamental sense, businesses with sustained high returns on equity are usually followed by appreciating stock prices, but not for the same specific reasons as a bond. In the real world, of course, investors in stocks don't just buy and hold.


In the long-run, the rate of return of a stock should equal its return on equity. Consider Microsoft. Microsoft continues to deliver unbelievable returns on equity of over 40 percent and has done so for decades. Yet for years, Microsoft shares have not followed suit.

The times are different. In the beginning Microsoft had lots of space in the software market to deploy its capital. So when Microsoft was generating a ROE of say 40 percent, back then it was able to continue investing that excess capital and generate a similar rate of return. What this means is that Microsoft could take a million dollars, invest it in its operations, and earn $400,000. Microsoft could then take the excess capital and still earn that same 40 percent. Microsoft was able to do this with billions of dollars and this was happening years before the Internet boom.

It is no surprise then, that Microsoft stock rocketed for many years after its IPO and why early investors, Gates, and employees got so fantastically rich off the stock. The company was compounding existing and excess capital at a phenomenal clip. Anytime you can do this for a sustained amount of time, the intrinsic value of a business mushrooms and eventually so will the stock price.

Now What?

Microsoft still generates returns on equity of over 40 percent, yet the stock price sits still. Microsoft is so huge and has so much cash, that it is now only able to generate those returns only the capital needed to run he business. It can no longer take the excess capital and redeploy it at such a high rate of return. This is why it paid that huge dividend a few years back. It made more sense payout some of that excess capital to shareholders than to reinvest back in the business.

Concentrate Your Bets

Anytime you locate a company that offers the talent and ability to redeploy its existing and excess capital at above market rates of return for any sustainable period of time, odds are the stock price will follow suit. An ability to earn excess returns on equity signals that the company offers certain competitive advantages not easily reproduced by its competitors.

In the 1980's Warren Buffett bet over 20 percent of Berkshire’s book value on the Coca Cola Company. Buffett noticed, among other things, that Coke was earning excellent returns on its equity and deploy the excess capital into other infant markets. Berkshire Hathaway itself is a huge capital deployment vehicle. It takes the float from its insurance company and any excess cash from its operating subsidiaries and invests the excess capital very successfully. Berkshire has risen an amazing 7,000-fold since Buffett took control of the company in 1965.

Profits and earnings growth are vital. But what businesses are able to d0 to with those profits sets apart great businesses from good ones.

In 1978, Warren Buffett wrote an article for Fortune Magazine titled "How Inflation Swindles the Equity Investor" In it he noted that there are only five ways to improve return on equity:

1. Higher turnover, i.e. sales
2. Cheaper Leverage
3. More leverage
4. Lower taxes
5. Wider margins on sales

Companies have the least control over tax levels, although management can certainly use creative accounting to temporarily alter the tax rate. An investor is better suited to focus on the others, as the ability to spot improved sales, prudent use of leverage, or cost cutting initiatives can lead one to excellent businesses.

All else equal, sales increase should create an increase in profits. Of course the quality of sales should be carefully examined. As sales increase, accounts receivable level should naturally follow suit. However, if receivables are demonstrating a trend of growing much faster than sales future troubles may lie ahead when it’s time to collect. Additionally, inventory management is important. The application of LIFO or FIFO will affect the profit statement differently during inflationary or deflationary periods.

When used prudently and wisely the use of leverage can increase returns on equity. Similarly, if a business can lower its cost of debt, the corresponding effect is a higher return on equity. Today we are seeing exactly how the mismanagement of leverage has affected those businesses participating in the credit markets. The painful lesson is similar to buying stocks on margin. If you are levered five to one, a ten percent return on the levered portfolio equals a return on equity of 50 percent. The same corresponding loss occurs with negative returns. Unfortunately, most businesses (1) fail to use leverage appropriately and opportunistically; and (2) employ leverage at alarming multiples to equity. The results, as we can clearly see, have been disastrous.

Wider margins are created in one of two ways: increasing prices or decreasing costs. Very few companies can raise prices at will without incurring competition or meaningful declines in volume. Again, this is why Buffett bet so big on Coke. For decades Coke has been steadily increasing the price of its famous syrup with no meaningful loss in market share as a result. As Buffett once quipped, "Who's going to risk saving a nickel over a product they put in their mouth?" Wrigley's chewing gum offers a similar example.

Profits count, but it's what you can do with those profits over time that really matters. (Source: Sham Gad Blog)

For the moment you assume that we take total assets that is Fixed Assets + Current Assets - Current Liabilities OR Shareholder funds + Debt which ever way you look at it.