ROCE and RONW

While analyzing a company, the most important thing you would like to know is whether the company is efficiently using the capital (stockholders' funds plus borrowed funds) entrusted to it.

While valuing the efficiency and worth of companies, we need to know the return that a company is able to earn on its capital, namely its equity plus debt. Those companies that earn a higher return on the capital it employs are more valuable than those which earn a lower return on their capital. The tools for measuring these returns are:

1. Return on Capital Employed (ROCE),
2. Return on Net Worth (RONW).

Return on Capital Employed and Return on Net Worth (stockholders funds) are valuable financial ratios for evaluating a company's efficiency and the quality of its management. The figures for these ratios are commonly available in business magazines (especially in Capital Market), annual reports and economic newspapers and financial websites.

A company raises its capital from two sources, namely debt and equity. The stockholders contribute the equity portion of the company's capital. The debt portion may consist of loans from banks and financial institutions, money raised through bonds, fixed deposits, and secured or unsecured loans obtained from directors and other private parties. Stockholders, who are the owners of the company, have a right to the annual profits of the company after all its expenses have been met. As described earlier, part of these profits are ploughed back into the accumulated reserves of a company, while the remaining profits are distributed to its stockholders in the form of dividends. The net worth (also known as stockowners' funds) of a company comprises its equity plus its accumulated reserves. Therefore, the total capital employed by the company in its business operations comprises net worth plus debt.

Turning now to profits. The net profit of a company is the residual surplus it earns after meeting all expenses, including noncash expenses such as depreciation on assets. The net profit is a useful figure, but it does not give us a true picture of a company's operating performance. To judge the operating performance we must look at a company's operating profit which is different from its net profit.

The figure for operating profit is arrived at after adding back taxes paid, depreciation, extraordinary one time expenses, and deducting extraordinary one time income and other income (income not earned through mainline operations), to the net profit figure. The operating profit of a company is a better indicator of the profits earned by it than is the net profit.

Return on capital employed

Return on capital employed (ROCE) is best defined as operating profit divided by capital employed (net worth plus debt).

ROCE thus reflects the overall earnings performance and operational efficiency of a company's business. It is an important basic ratio that permits an investor to make inter company comparisons.

Return on net worth

Return on net worth (RONVV) is defined as net profit divided by net worth. It is a basic ratio that tells a stockholder what he is getting out of his investment in the company.

ROCE is a better measure to get an idea of the overall profitability of the company's operations, while RONW is a better measure for judging the returns that a stockholder gets on his investment. The use of both these ratios will give a broad picture of a company's efficiency, financial viability and its ability to earn returns on stockholders' funds and capital employed.

PEG ratio

PEG is an important and widely used ratio for forming an estimate of the intrinsic value of a stock. It tells you whether the stock that you are interested in buying or selling is under priced, fully priced or over priced.

For this you need to link the P/E ratio to the future growth rate of the company. This is based on the assumption that the higher the expected growth rate of the company, the higher will be the P/E ratio that the company's stock commands in the market. The reverse is equally true. The P/E ratio cannot be viewed in isolation. It has to be viewed in the context of the company's future growth rate, The PEG is calculated by dividing the P/E by the forecasted growth rate in the EPS (earnings per stock) of the company.

As a broad rule of the thumb, a PEG value below 0.5 indicates a very attractive buying opportunity, whereas a selling opportunity emerges when the PEG crosses 1.5, or even 2 for that matter. The catch here is to accurately calculate the future growth rate of earnings (EPS) of the company. Wide and intensive reading of investment and business news and analysis, combined with experience will certainly help you to make more accurate forecasts of company earnings.